Bear Stearns Cos. (NYSE: BSC), a relatively small player in the commercial real-estate financing business recently, made a big bet last year when it agreed to lead the effort to sell the debt financing the buyout of Hilton Hotels Corp., by far the biggest commercial mortgage deal ever.
With the commercial mortgage-backed securities market struggling, that deal and the CMBS debt Bear is holding now fall in the lap of J.P. Morgan Chase & Co. (NYSE: JPM).
As part of its agreement to buy Bear Stearns, J.P. Morgan gets $16 billion of commercial real-estate loans on Bear's balance sheet, including some of the Hilton debt. The biggest question facing the already jittery commercial mortgage market is whether the bank will try to dump all that debt.
The $20 billion leveraged buyout of Hilton by private-equity firm Blackstone Group LP closed in October, shortly after the market seized up. Bear agreed to lead a consortium of banks seeking to sell off $8.4 billion of loans as bonds in what could be the largest commercial mortgage-bond offering to date. In December, Moody's cut its ratings on Bear, partly blaming the firm's "concentrated risk" from the Hilton deal.
That mammoth CMBS offering, in which Bear Stearns is part of a consortium of lenders including Bank of America Corp. (NYSE: BAC), Deutsche Bank AG (NYSE: DB), Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley, has been stalled during the prolonged credit crunch. The deal was even riskier because it is a single-borrower issue, meaning Blackstone is the only borrower in the pool of loans. Most other such offerings have multiple borrowers, with the risks spread over many different people as well as different kinds of commercial buildings and geographic locations.
The deal also comes at a bad time for the hotel industry. Hotels are the first commercial sector of the real-estate industry to feel an economic slowdown, and the pain could be made worse by a big jump recently in hotel construction, which has raised the supply of rooms. Hotel construction starts are expected to stay strong this year and next, potentially leading to a glut of rooms, according to a study by PricewaterhouseCoopers.
The immediate fear in the commercial mortgage-backed securities market is that J.P. Morgan will sell the Bear Stearns bonds it inherits on the cheap, further depressing the already weak market. The temperament of the CMBS market — at least as it is measured by the CMBX, an index that tracks the performance of the commercial-mortgage bond market — has been very volatile since last Thursday, when news about Bear Stearns's liquidity problems broke.The risk perception on some portions of the index surged to record levels Friday before falling at the end of the day Tuesday.
But analysts say J.P. Morgan is unlikely to flood the market with Bear Stearns's bonds, because the Federal Reserve guaranteed $30 billion of Bear's holdings. "J.P. Morgan is perfectly comfortable with the assets that we're acquiring" because of the Fed's guarantee, said Bill Winters, co-chief executive officer of J.P. Morgan's investment-banking division, during a conference call Sunday.
In fact, the kind of commercial real-estate risk that J.P. Morgan will be inheriting from Bear Stearns could be minimal. Bear Stearns hedged its commercial real-estate portfolio, so its net exposure, once the offsetting transactions are factored in, is "significantly less" than $16 billion, says Blaine Frantz, a senior vice president at Moody's Investors Service.
Plus, Frantz says, "the government is there for J.P. Morgan," pointing to the Fed's decision to take over $30 billion of Bear Stearns's least-liquid securities, which include both commercial and residential mortgage bonds. (J.P. Morgan and the Fed haven't broken down those assets by types of loan.)
Bear Stearns has had a declining role as a CMBS underwriter globally over the past four years, falling from No. 4 in 2004 to No. 12 last year, according to data tracker Dealogic. Morgan Stanley and Wachovia Corp. were No. 1 and No. 2, respectively. Rival Lehman Brothers Holdings, meanwhile, had market share twice the size of Bear Stearns' and also has been a more active provider of commercial mortgages and bridge loans, which fill the gap between the first mortgage and the cash down.
The $36.1 billion in commercial mortgages and related securities that Lehman reported Tuesday was down from $38.9 billion at the end of November. The firm wrote down the value of those holdings by $1.1 billion in the quarter ended Feb. 29. After taking hedges into account, the net write-down was $700 million.
Delinquencies on commercial mortgages continue to be very low, about 0.40 percent, said Lehman's Chief Financial Officer Erin Callan during a conference call. Referring to the firm's commercial mortgage holdings, she said: "Our valuations reflect how the market is pricing these positions, not the fundamentals of the asset class."