Bond Index Draws Doubters

Indicator Is Faulted on Call
For Commercial Real Estate;
Critics Seek More Disclosure

By LINGLING WEI
February 27, 2008; Page B13

Complaining that a credit-market index is making a wrong call about the prospects for commercial real estate, some investors and analysts are calling for more transparency in the index, namely a disclosure of how many trades are taking place.

The index, called the CMBX, reflects the values of bonds backed by mortgages on office towers, hotels and the like. The index has become controversial because it is trading at levels that would imply a looming collapse of the U.S. commercial real-estate market. However, that scenario has been questioned by many industry experts who say that market fundamentals remain solid, even if the market is softening. And these critics have become vocal about the possibility that the index is being abused by people looking to make a quick buck.

“Real-world events are being obscured by an index easily manipulated by investors,” says analyst Richard Bove at boutique investment firm Punk Ziegel & Co., who is in Tampa Bay, Fla.

But the company that runs the index says it can’t meet such requests for greater transparency because of the way the index works.

The CMBX, which began trading in March 2006, was created by a group of Wall Street firms to establish a derivatives market for commercial real estate, allowing investors to make bets on how they think the property market would perform. The CMBX is supposed to reflect the performance of commercial-mortgage-backed securities, which are pools of mortgages that are sliced up and sold to investors as bonds. But the market for these bonds has virtually shut down, making it hard to determine what these bonds are worth.

Thus, the index has become a de facto benchmark for pricing commercial-mortgage bonds. The upshot: Issuers of these bonds have to increase the yields to higher and higher levels to sell them, making it more expensive for people to invest in commercial real estate. For instance, the safest portions of a $1.2 billion commercial-mortgage-bond deal led by Morgan Stanley two weeks ago — the first such issuance so far this year — were priced at about three percentage points over the 10-year Treasury. A year ago, yields on comparable AAA-rated bonds would have been less than one percentage point over the benchmark.

Tighter and more costly credit amid a slowing economy, some analysts say, could become the chief reason for declining commercial-property values in the coming years. Moody’s Investors Service recently said it expects property prices to ultimately decline by 15% to 20%, reversing the gains of the past two years. As a result, people who have found their fortunes hurt by the performance of the index are getting suspicious as to who is actively trading on it and whether those traders are making a bad situation worse. “It’s troubling to us,” says Kieran Quinn, chairman of the Mortgage Bankers Association, which represents lenders. “We don’t know who’s behind this.”

Yet, they think they have a pretty good guess. They point to hedge funds, which they believe are flocking to the index to make bets against the commercial-property market, which in turn causes the CMBX to imply a record level of perceived risk of commercial-mortgage defaults. Those short-sellers believe the commercial-property market will get worse and use the index like an insurance policy and will get paid if defaults rise.

In theory, the index also should reflect the trading of those who want to go “long,” betting that the property market will improve. But Darrell Wheeler, global head of securitized strategy at Citigroup Inc., notes that there is a dearth of investors going long with the index in part because of the lack of disclosure of the trading volumes for the index. “Until such a volume system is implemented,” Mr. Wheeler says, “traditional real-money investors such as insurance companies and pension funds are understandably reluctant” to go long, leaving its performance purely driven by short-sellers.

As compared with stocks in publicly traded companies and the well-established stock indexes, where investors can easily track their trading volumes, the CMBX isn’t traded in traditional exchanges but in private transactions. Market participants say the trading could be so thin sometimes that a single trade of $10 million could cause a big swing in the index.

Markit Group Ltd., a London-based company, says on its Web site that it works with the trading desks of a consortium of Wall Street firms to calculate the index. Markit Managing Director Ben Logan says it is impossible for the company to report the trading volumes for the index because the company itself doesn’t even know. Unlike stock trades, which are usually handled by a stock exchange, CMBX trades are direct transactions between buyers and sellers. “There is no place where volumes are available,” Mr. Logan says.

The solution to the problem, says Mr. Bove of Punk Ziegel, is for securities regulators to “require an exchange mechanism where investors can see clearly the bids and offers and trading volumes for the index.”

Write to Lingling Wei at lingling.wei@dowjones.com

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