Traders bet commercial mortgages to follow subprime

NEW YORK (Reuters) - Traders who bet against the U.S. residential mortgage market ahead of the subprime crisis and won are now setting their sights on the commercial real estate sector.

Hedge funds and other traders that have profited from huge drops in an index tied to home mortgage loans made to people with weak credit are now aiming at sister indexes based on loans for office buildings and hotels.

That strategy challenges the view of other analysts and investors who maintain that commercial real estate's fate will not follow that of the battered residential sector.

Expectations of rising defaults in the $850 billion commercial real estate market (CMBS) amid some looser underwriting in recent years has become a common refrain, giving investors a reason to short the market, analysts said. CMBS underwriters until recently were selling securities with fewer protections for bondholders, leaving investors vulnerable to the kind of losses that hit home mortgage buyers.

Among hedge funds and other speculators, the strategy used with ABX-HE subprime mortgage derivative indexes is now being applied to the "CMBX" index, pushing yields on the index sharply higher this month as data on U.S. housing worsened.

"The CMBX has been targeted for technical shorting in a manner similar to the ABX," said Christopher Sullivan, chief investment officer for the United Nations' employees federal credit union in New York. The presumed credit fallout indicated by the index "seems excessive," he said in an interview.

Yield spreads on the "BBB-" CMBX index that follows 25 commercial mortgage-backed securities have jumped almost 50 percent since October 10 to a record high 786.5 basis points as of Monday. The move represents a spike in bearish bets that had been only gradually mounting on concern the subprime crisis would infect the economy and crimp cash flows that support commercial loans.

Embedded protection, or "subordination" on "BBB" bonds as high as 14 percent in 1997 slipped to just 3 percent last year, Kevin Cronin, chief investment officer at Putnam Investments, said in a recent interview. Applying the lower subordination levels to 1997 and 1998 deals, one in four would have suffered some loss instead of the one in 30 that occurred, he said.

"Everyone's been saying that defaults in CMBS have been relatively low and there's no risk that those transactions could be hit," said Cronin, whose team has been sticking with the safest, "AAA" CMBS.

Current delinquency rates on commercial loans hover around 0.32 percent today, and will probably rise to 2 percent in a couple of years, said Darrell Wheeler, head of CMBS research at Citigroup Global Markets in New York. By contrast, subprime mortgage delinquencies near 16 percent are quadruple what they were two years ago, Wheeler's data shows.

Rising delinquencies "wouldn't be the end of the world for this market," he said.

Vigilance from hawkish investors who, unlike subprime mortgage buyers, have weathered previous downturns will buoy CMBS quality, he said. Underwriting on newer issues has improved, he said.

"There are probably 200 different experts that have been following this market for years and I don't think that they feel they've been hoodwinked," Wheeler said. "I expect the buy side has all the confidence in the world about this product."

Commercial property values and rents are still rising in contrast to residential markets.

Vornado Realty Trust (VNO.N), which develops and builds office and retail properties, on Tuesday said funds from operations rose 8.2 percent last quarter with help from higher office rents. Simon Property Group Inc (SPG.N), the largest U.S. owner of shopping malls, on Monday said demands for store space boosted its funds from operations by 13 percent.

CMBX bonds supported by loans in retail and office space, hotels and multifamily housing are well diversified relative to ABX bonds that are all subprime home equity, Bank of America strategists Glen Taksler and Ward Bortz said in a client note.

Some hedge funds have indicated they may unwind short positions, though the CMBX is still vulnerable given negative sentiment in credit markets, Citigroup's Wheeler said.

"People made money from shorting the ABX and so far made money in shorting CMBS, and it really is a question of how far that goes, he said. "It's trading on momentum and the real losses aren't there."

(Additional reporting by Ilaina Jonas in New York)