FNCE 894: Trade Idea #1

Executive Summary
I propose a long position in the single name CMBS security J.P. Morgan Chase Commercial Mortgage Securities Pass-Through Certificates Series 2004-CB8 (JPMCC 2004-CB8), Class D. This trade will implement the long term bullish view I have on real estate without exposure to the near term volatility seen in other mortgage products in the U.S. Aggregate index that are highly sensitive to rates due to the uncertainty in QE3 and other macroeconomic factors.

Trade Rationale
Recovery in commercial and residential real estate will continue without regard to Fed decisions on QE3. Feds commitment to keep short-term rates near zero until the unemployment target is met means higher commercial property valuations. There should be a mean reversion of 10-year treasury to cap rate spreads as they are near the all-time highs. CMBS credit is the best way to take a bullish position on real estate.

There has been a large amount of uncertainty surrounding the future of QE3 and short-term rates causing increased volatility in agency MBS and other interest rate sensitive securities. The most recent FOMC minutes from January allude to many participants becoming concerned about the risks of further asset purchases1, while a February 11, 2013 speech by Vice Chair Janet Yellen mentions the importance of fiscal policy and residential investment to economic recovery2. However, real estate in its pure form, meaning the hard asset price, should benefit from either direction the Fed decides on going forward. If QE3 continues, real estate prices should benefit from the inflationary effects from Fed purchases. On the other hand, if there is a sharp recovery and unemployment improves, QE3 will come to an end, but investment into residential and commercial real estate will begin. Having the view that real estate is not highly sensitive to short term monetary policy, I believe the growth in commercial real estate prices will remain stable, if not improve in the near future. The Moodys/RCA CPPI Core Commercial Index (CPPI) indicates that the year-over-year growth in the core commercial real estate market (Retail, Industrial, and Office) has been approximately 7-8% for the past two years, improving since the third quarter of 2009 (Figure 1).

1 2

http://www.federalreserve.gov/monetarypolicy/fomcminutes20130130.htm http://www.federalreserve.gov/newsevents/speech/yellen20130211a.htm

FNCE 894: Trade Idea #1 Figure 1. YoY Growth in Moodys CPPI Core Commercial Index3
20.0 10.0 0.0 -10.0 -20.0 -30.0 -40.0 CPPI YOY Change (%)

In December 2012, the Fed announced that it would tie its policies to unemployment and inflation by keeping short-term rates near zero until unemployment reaches 6.5% or inflation reaches 2.5%. Creating a mandate to decrease unemployment to 6.5% could inherently mean a directive to increase commercial real estate prices as well. Since the zero policy period the CPPI index has been highly inversely correlated to the unemployment rate as seen in Figure 2. Assuming this inverse correlation continues, it would imply an increase of approximately 20% in commercial real estate prices as approximated by the predicted CPPI index and unemployment rate from a log regression. Figure 2. Relationship Between CPPI and Unemployment4
200 190 180 5.00 5.50 6.00 6.50 7.00 7.8%

6.5%

170
160 150 140 130 120 110 138

171

7.50
8.00

8.50
9.00 9.50 10.00

CPPI
3 4

CPPI Pred

UE (%)

UE (%) Pred

Source: Bloomberg Source: Bloomberg

FNCE 894: Trade Idea #1 The spread between the 10 year treasury and cap rates can be interpreted as the perceived risk on commercial real estate investing. Spreads to the 10-year tend to be close to or lower than zero during times of high asset valuation as seen during the recent housing bubble as well as the one in the 80s. Given that spreads are currently at or close to all-time highs (Figure 3.), depending on which property type, there should be a tendency to revert to the mean going forward. Additionally, the inevitable rise of rates from near zero will tighten the spread. Figure 3. Cap Rate Spread to 10-year Treasuries by Property Type5

The best way to take a position on this bullish view of real estate is to buy CMBS credit exposure. The agency MBS positions in the U.S. Aggregate are very rate sensitive and there are no available nonagency MBS credits to trade. Further, the residential market is not as robust as the commercial market. The commercial market is more responsive to price corrections due to lack of government intervention as we have seen on the residential side. I chose JPMCC 2004-CB4, Class D, out of the available CMBS bonds in the U.S. Aggregate because I felt that it offered the highest adjusted yields. The market is pricing in too much credit and extension risk in my view.

Model Inputs and Assumptions

I used the Bloomberg CMBS cash flow model to price this bond. The major assumptions used were: Prepayment speeds o Defaults vs refinancing Loss severities Recovery lag

Source: NCREIF

FNCE 894: Trade Idea #1 Prepayment speeds. Historical data shows that 60+ delinquencies across most vintages have leveled out or are slowing down as shown in Figure 4. JPMCC 2004-CB8 consists of primarily 2004 and 2003 originations, 56% and 43%, respectively. Given the leveling off of delinquencies and the view that real estate asset prices will rise, collateral performance in the deal should improve as well. I assumed 100% of the underlying loans that are currently on the servicer watch list will default at the maturity date. Furthermore, I assumed the performing loans will be able to refinance when they come due because of available liquidity and renewed interest in the CMBS market. Substantially all of the loans are balloon, IOs or balloon IOs.This prepayment schedule is illustrated in Figure 5. Figure 4. 60+ Delinquency by Loan Origination Vintage6

Figure 5. Loan Maturity Schedule and Prepayment Breakdown7

$90 $80

$70
$60

$ mm

$50 $40 $30

$20
$10 $-

Refinance

Default

6 7

Source: Trepp, calculated from IRP data (prior to Mar 2009) and Trepp-derived data (Mar 2009+), as of 1/2013 Source: Trustee Reports

FNCE 894: Trade Idea #1 Loss Severities. Median historical loss severity over the past 12 months from default liquidations was 54%8. Given the vintage of JPMCC 2004-CB8, I assumed average severity will run at 50%. This assumption is most likely on the high side. Recovery Lag. The average loan workout lag was 21 months over the past 12 months9. For the same reasons as the loss severity assumption, I assumed the average lag time will run at 20 months. Under this base case run, the model predicts an 11.7% yield, however, the model does not take modified loans into consideration. I would price this bond closer to 5-6% area due to maturity extensions bringing the bond payoff into 2019-2020 rather than 2015 as shown in Figure 6. I do not believe there is risk of principal loss to the Class D bond given the amount of subordination it currently has (14% defeasance adjusted) and its low current LTV ratio of 67%10.

Scenario Stresses I ran scenario stresses by moving the default assumption using the same maturity schedule in Figure 5 under the same severity and lag assumptions. Again, these yields are higher than the realistic value when considering the modified loans (Figure 6). Figure 6. Base Case Pricing and Scenario Stresses11
JPMCC 2004-CB8 D mtge
Scenario Name Price Yield WAL Principal Window Duration I Spread Z Spread N Spread E Spread First Loss Date $ Bond Loss % Bond Loss $ Collateral Loss % Collateral Loss Defeased Adj. C/E Min C/E Min C/E Date

1
Base 92.273 11.707 1.23 04/14-04/15 1.13 1153.3 1105.6 1103.8 1131.7 No Loss 0 0.00 21,931,380 1.75 14.08 12.05 4/12/2013

2
Default 1 92.273 10.668 1.44 04/14-05/15 1.31 1047.6 1009.2 1007.2 1027.4 No Loss 0 0.00 25,505,413 2.03 14.08 12.05 4/12/2013

3
Default 2 92.273 8.331 2.31 12/14-10/15 2.10 805.2 788.2 789.8 789.1 No Loss 0 0.00 37,676,234 3.00 14.08 12.05 4/12/2013

4
Default 3 92.273 7.892 2.63 07/15-09/16 2.39 757.5 741.0 742.1 741.5 No Loss 0 0.00 49,474,535 3.95 14.08 12.05 4/12/2013

5
Default 4 92.273 7.162 3.49 09/15-01/19 3.06 669.6 646.2 655.5 645.8 No Loss 0 0.00 60,911,290 4.86 14.08 12.05 4/12/2013

8 9

Goldman Sachs CMBS Commentary Goldman Sachs CMBS Commentary 10 Source: Bloomberg 11 Source: Bloomberg CMBS model

FNCE 894: Trade Idea #1

Trade Details and Expected Return

I implemented the following trade: Security Buy JPMCC 2004-CB8, Class D Volume (M) $9.5

This trade does not affect the duration of the overall portfolio materially because it is not very sensitive to rates, but rather extension risk and to a certain extent, credit risk. It adds 10 basis points to the portfolio yield to worse along with increasing the TEV marginally. I sized the trade to stay within the tracking error of 150 bps but taking as much advantage of the upside on the trade. Metric BARCLAYS OAD (yr) (Portfolio impact) Yield (Portfolio impact) 5yr KRD (Portfolio impact) 10yr KRD (Portfolio impact) 30yr KRD (Portfolio impact) TEV (bps) (Portfolio impact) Total Vol. (bps) (Portfolio impact) Sharpe Ratio (Standalone) Expected Return (Standalone) Impact No impact +10 bps No impact No impact No impact +0.50 bps +0.52 bps 7.4 12.10% 3.4 5.0-6.0%

Adjusted Shrape ratio (Standalone)* Adjusted Expected Return (Standalone)*

* Adjusted for extension

Risks
Loan Modification Risks: The biggest risk to this bond in my opinion is loan modifications. Its levered position in the capital stack makes it either a one year or 20+ year bond. The cash flow model from Bloomberg used in this analysis is good, but not as good as other industry specific cash flow models such as Trepp. The Bloomberg model does not allow for loan modification assumptions which could materially affect bond yields. A modification to the rate could create lower than expected yields because its pass-through rate is based on the weighted average rate of the underlying fixed rate collateral. Further, term extensions would delay cash flows and increase duration as well as increase severities if the loan ultimately defaults. Double Dip Recession: If the overall economy takes a severe turn for the worse, credit based real estate assets will undoubtedly suffer as well.

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