®
Do Current CMBS Pricing
Conventions Make Sense?
TOWER OF BABEL
Bond trading used to be much
easier. Virtually all fixed income
securities were offered on a spread
to Treasuries basis, which facilitated
comparisons across markets. Now,
methods of pricing are all over
Rubinstein the map. In commercial mortgage-
backed securities (CMBS), invest-
ment-grade bonds are priced on a spread to swaps basis
(using an interpolated average life and the “J” curve
method), but below-investment-grade bonds are priced
on a spread to interpolated on-the-run Treasuries, using
the “I” curve method. CMBS IOs (interest only) are also
priced as a spread to interpolated Treasuries, but
illogically, to a much longer maturity than their cash flow
average lives, which can grossly understate the spread
earned in comparison to other bonds, particularly in a
steep yield curve environment. ABS pricing is worse.
They use swaps, “E” curves, “N” curves, EDSF and, on
occasion, still price to unique, off-the-run Treasuries.
Similarly, residential MBS, derivatives, corporate bonds,
and other fixed income securities all use their own,
distinct pricing conventions.
Custom pricing conventions, like any specialized
language, have benefits, but there are also costs and
inefficiencies. Few players now understand all of the
pricing conventions, which makes comparisons across
markets a difficult, time consuming and exacting task at
best. Converting all prices to a common basis is not a
trivial task. In this article, we ask whether the new
conventions used to price CMBS are (1) still logical, and
(2) worth the added cost and complexity. With that goal
in mind, we start by looking at how we got here, what
“here” really means, and then discuss where we might go
from here, and why.
A BRIEF HISTORY OR HOW DID WE GET INTO THIS
MESS ANYWAY?
Most of you recall the unprecedented dislocation of
fixed income spreads (when measured with respect to
Treasury yields) in the Fall of 1998. The volatility was
disorienting because the data was sending out strong but
conflicting signals. On the one hand, wide spreads
suggested high levels of risk.1 On the other, the economic
50 CMBS WORLD™
Peter Rubinstein
data was strong, indicating a low level of risk1. The
message in the economic data was supported by the fact
that triple-A yields were largely stable: the spread
widening came solely from the rally in Treasuries. In
CMBS, the confusion was amplified. The market was too
young to independently arrive at a risk premium. An
outside proxy for credit risk was needed.
Confusion alone would probably not have changed
market pricing conventions, but in addition, the turmoil
caused a lot of people to lose a lot of money. Most trading
desks had hedged their positions by selling Treasury
bonds short. Many issuers hedged their pipeline the
same way. Obviously, some investors also used Treasuries
to hedge. They all took a bath because the hedges lost
money, and the assets either lost money, or barely
appreciated. Faced with the poor hedging results and
conflicting informational content, the market began to
search for an alternative benchmark. The search gained
urgency when government surpluses started to shrink
the supply of Treasury bonds. A number of alternatives
were examined, such as Agency debentures, but the
swaps market offered certain key advantages. The
market was large, had broad participation, and many
players who may never actually have traded in swaps
still used swap spreads on a regular basis to establish
an alternative benchmark for relative value. Further,
movements in swap spreads appeared to be well
correlated with other asset spreads. Some participants
actually claimed that swap spreads caused other asset
spreads to move. In March 1999, the ABS market offered
its first deal priced to swaps (AMEX 99- 1). CMBS and
other segments of the ABS market soon followed.
WHERE ARE WE NOW? A SWIPE AT SWAPS
Was the shift to swaps good? Initially, it appeared so.
Numerous regression studies were produced to show the
high correlation between swap spreads, CMBS spreads,
and many other fixed income spreads. The claim was
made that swaps are a good proxy for credit risk and this
became a major supporting argument for using swaps
as a benchmark. But there were problems that were
overlooked too. First, the correlations did not always
hold. Some of the historical regression studies looked
good because they skipped periods of time where swap
spreads did not correlate well. That should have been
Do Current CMBS Pricing Conventions Make Sense? (cont.)
a tip-off about the consistency of using swaps as a
benchmark.
This consistency problem has now showed up several
times in real life. For example, Treasuries rallied after the
World Trade Center attack, just like in 1998, due to a flight
to quality, but this time around, swap spreads tightened,
just the opposite of what would be expected if swaps were
a good proxy for credit risk. In CMBS, spreads to swaps
decoupled after the World Trade Center attack and
widened significantly, yet they remained stable to
Treasuries. Similarly, the 10-year part of the swap curve is
periodically distorted by unusually high demand from
MBS servicers, originators and hedge funds, all of whom
can use swaps to offset the loss of duration suffered from
rapid prepayments. And, as we know from past experience,
corporate issuance (or the lack thereof), the slope of the
Treasury curve, the supply of Treasury bonds, and other
factors, many of which are unrelated to credit, influence
the level and shape of the swaps curve.
Note also the interpretation of the high correlations in
these regression studies has not always been right.
Regressors in a regression are called “explanatory”
variables, but they don’t actually explain anything, a caveat
highlighted in almost every econometrics textbook.2 Even
when there is a causal link, the direction of causality is not
specified by the regression. In other words, if you switched
the “dependent” and “independent” variables in a typical
swap spread versus CMBS spread regression, you would
get the same high R2, “proving” the absurd statement that
the movement in CMBS spreads “causes” swap spreads to
move!
Theory
What is missing from the swaps studies is a theory that
establishes a direct cause and effect linkage between swap
spreads and CMBS (or other asset) spreads. The theory
doesn’t exist, however, because the relationship between
swaps and the rest of the fixed income market is not causal.
What actually drives pricing in the markets, beyond the
pure and simple supply and demand for money which is
captured in overall interest rates, are multiple sources of
risk that come in two flavors: systematic risk and
unsystematic risk. These risks often act independently of
each other and generally occur simultaneously, which has
induced some of the odd results we have seen over the past
few months, for example, the credit induced rally in
Treasuries coupled with the tightening in swaps. To
understand these impacts, you need to look at the effect of
each risk on a stand-alone basis, and then realize that at any
point in time, either one can dominate in determining the
ultimate prices in the market. Systematic risks operate like
the tide causing all ships to rise and fall together. They
stem from macro level events, like the current war and
recession we are now in. Since systematic risks cause all
bonds to respond together, under pure systematic risk,
swaps (which are credit sensitive) respond along with other
bonds, and so perform well as both a benchmark and as a
hedge. There is a twist, however. Under systematic risk, ®
Treasury bonds usually break away from the rest of the
market because they are the only (credit) risk-free
alternative in the world. As the only safe haven, an
exaggerated amount of demand for safety gets channeled
into the Treasury market, causing an exaggerated widening
in spreads to Treasuries. This is exactly what happened in
1998, and shows why swaps, under pure systematic risk, are
a more stable benchmark and better hedge than Treasuries.
Note also that in these circumstances, it appears as if swaps
“ Custom pricing conventions, like any specialized
language, have benefits, but there are also
”
costs and inefficiencies.
cause other assets to widen, but that is only because the
swaps market is the most liquid and highly watched market
next to Treasuries. We simply see the widening there first.
Swaps spreads are a good signal, but not a cause.
On the other hand, markets also experience
unsystematic risks, which are often the result of technical
factors specific to one or just a few markets. The swaps
market is subject to these specific, unsystematic risks just
as much as any other asset, and sometimes the impact of
unsystematic risks dominate in pricing, which explains why
swaps sometimes fail as a benchmark and a hedge, and why
swap spreads sometimes appear to behave erratically. It
explains, for example, why, in the post World Trade Center
attack, swap spreads tightened (instead of widening to
reflect increased systematic credit risk as in 1998) as
Treasuries rallied. The combination of the steepening
curve and demand by mortgage market participants for
receive-fixed swaps dominated the credit induced
widening. So empirically, what we have seen over the past
few months is that both treasury bonds and swaps
sometimes fail to work as expected, both as benchmarks
and as hedges.
How to Proceed
The fact that swaps are merely a signal, and the fact that
risks specific to the swap market can make them a poor
benchmark and a poor hedge is a complete reversal of the
thinking in 1998 when we were convinced that swaps were
the answer. The essence of the problem is that there is no
one number that will always function as a stable
benchmark, which means we must compromise. The best
we can do is identify the performance criteria that define a
good benchmark, and then see how the various alternatives
stack up. I suggest starting with the following criteria, but
do not claim this to be a complete list:
SUMMER 2002 51
 Do Current CMBS Pricing Conventions Make Sense? (cont.)
1. Tamper Proof. While this criterion may be obvious,
unfortunately it may not be possible to find a benchmark
®
that is truly safe from manipulation. Even the Treasury
market suffered manipulation a number of years ago.
The more tamper proof, however, the better.
2. Liquidity and High Trading Volume. High trading
volume insures that the benchmark can always be
observed and that it reflects all information in the
market, while liquidity (i.e., a low bid-ask spread)
insures that the value is accurately measured. Liquidity
also is important because there will be a natural
tendency to use the benchmark as a hedging vehicle,
although we submit that hedging strategies need to be
independent of the choice of benchmark because
different assets contain different mixes of risk.
3. Broad Participation. A relatively small number of
participants can make a liquid market and sustain a high
trading volume, but for a benchmark, it is even better
if there are many participants trading in the market.
It makes the market more stable and allows more
information to be reflected in the marketplace.
4. Transparency. It should be easy to understand how a
benchmark’s value is calculated. For example, just about
everyone in the fixed income markets knows how to
calculate the present value of a Treasury bond at any
point in time, but fewer people know how to value a
seasoned interest rate swap several years after it was
created.3
5. Consistency. The market factors that move the
benchmark’s price and the rules that define the
benchmark and its marketplace should be stable. For
example, Treasury bonds recently failed in this area
when the Treasury changed the rules by announcing the
suspension of the 30-year bond. It put undue pressure
on the 10-year bond and will effectively eliminate the
longest benchmark. Of course, swaps have also failed in
this area; for example, when mortgage originators
recently swamped the swap market with demand for
received-fixed contracts to try and offset the duration
they lost in the mortgage market.
SO, WHAT SHOULD WE DO?
My ideal: new issue 10-year triple-A CMBS should
trade in the secondary on an absolute dollar price basis, or
perhaps on a dollar price “behind” some other, more liquid,
asset. People are perfectly capable of figuring out yields
and spreads on their own. Absolute yield levels would also
work, although yield levels introduce the complication of
making prepayment and default assumptions.
Traders tell me that these suggestions are a pipe dream,
but remember, GNMA passthroughs did not always trade
on an absolute price basis either. Realistically, however, the
52 CMBS WORLD™
CMBS market needs to be larger, and the product needs to
be more homogenous, before participants can consider
buying and selling on just a dollar price basis. Given the
impracticality of pricing on a dollar basis, we submit that
the second best solution is to abandon swaps and price
CMBS on a spread to Treasuries basis. Corporate bonds,
agency debentures and other major asset classes are still
quoted this way, and CMBS structures and convexity are
far more like corporate bonds and agency bonds than most
ABS and residential MBS. Further, Treasuries have the
best liquidity, best transparency, broadest participation,
probably the best protection against tampering, and
probably the highest trading volumes. The downside is
that Treasury bonds are not always consistent. The U.S.
Treasury occasionally changes the rules and there is not
much that can be done about that. Note, however, that the
distortion caused by periodic flights to quality is well
understood and should not cause a problem in the markets.
In fact, you can argue that the fact that triple-A yields in
1998 remained relatively constant in the face of a flight to
quality is confirmation that the markets can correctly
equate the risk and reward embedded in each asset
separately from movement in Treasuries. The biggest
problem with using Treasuries as a basis, many will argue,
is that they can, and sometimes have, failed when used for
hedging purposes. So have swaps, and the cost of going in
and out of swaps is much more expensive. Realistically,
hedging strategies need to be independent of the pricing
benchmark because empirically, no benchmark works well
all of the time as a hedge. Hedging is still an art as much
as a science. ❑
Peter Rubinstein, Ph.D., is Managing Director at Bear, Stearns
& Co. Inc.
1
For example, real (i.e., inflation adjusted) oil prices were
approaching all time lows, and interest rates had come way down,
both of which dropped the cost structure of our economy, made
investment more attractive, and put more money in consumers’
pockets. In addition, the government was running a huge surplus,
unemployment was approaching lows not seen since 1970, and
weak foreign economies made imports cheap.
2
Peter Kennedy, in “A Guide to Econometrics,” 3rd Edition, MIT
Press, p. 68, perhaps says it best: “It is usually assumed that
movements in the dependent variable are caused by movements in
the independent variable(s), but the existence of a relationship
between theses variables proves neither the existence of
causality nor its direction” (emphasis added).
3
A good discussion of how swap prices are tied to the Eurodollar
futures market can be found in Chapter 15 of “Derivatives” by Fred
D. Arditti, Harvard Business School Press, 1996.