Bailing Out a Sea of Debt: The CMBS Crisis Nobody Could Fix Fast Enough
This is post 6 in my series on The Commercial Real Estate Tsunami: A Survival Guide for Lenders, Owners, Buyers, and Brokers by Tony Wood, with a foreword by Matthew Anderson (ISBN: 978-0-470-63637-4, published by John Wiley & Sons, 2010). Chapter 5 is different from the rest of the book. It’s written by Dr. Sam Chandan, President and Chief Economist of Real Estate Econometrics and an adjunct professor at Wharton. This is the deep analytical chapter. And honestly, it’s the one that connects all the dots.
Previous post: Phase Four: The Run-Up
Who Is Sam Chandan?
Before getting into the content, it’s worth noting who wrote this chapter. Dr. Chandan was regularly quoted in the Wall Street Journal, Bloomberg, Reuters, the Financial Times, and Forbes. Tony Wood says his reputation for forecasting accuracy is well known throughout the industry. So when this guy writes a chapter called “Bailing Out a Sea of Debt,” you pay attention.
The CMBS Market Was Basically Dead
By 2009, the commercial mortgage-backed securities (CMBS) market had gone from barely any nonperforming loans in early 2008 to a steep climb in defaults. The government’s main response was expanding the TALF program to include CMBS. The idea was to restart securitization and improve liquidity for existing securities.
But here’s what Chandan points out honestly: as a practical matter, TALF didn’t do much to change the market’s broader problems in 2009. It was “warmly received” when announced, sure. But the actual impact on the ground was limited.
The Treasury also changed tax rules to make it easier for servicers to modify loans in securitized mortgage pools. Before the change, modifying a loan inside a REMIC (Real Estate Mortgage Investment Conduit) risked triggering tax penalties. So servicers basically couldn’t negotiate with struggling borrowers until things got really bad. The new rules allowed earlier action, but Chandan isn’t convinced they solved the core problem. He calls out the “moral hazard and scalability” issues that the new rules completely ignored.
His verdict: the changes removed a disincentive, but they were “hardly a panacea.” By addressing surface-level concerns without fixing the underlying structural problems, these policy responses might actually prove counterproductive.
That’s a bold thing to say while the government was patting itself on the back.
The Stuyvesant Town Disaster
Chandan uses the Peter Cooper Village and Stuyvesant Town case as a perfect example of everything wrong with the CMBS market. If you don’t know this story, buckle up.
Tishman Speyer and BlackRock bought this massive 11,200-unit apartment complex in Manhattan. The purchase price worked out to more than $480,000 per unit. The total mortgage debt was $4.4 billion. And here’s the kicker: the property’s actual cash flow at the time of purchase was well below what was needed to cover the debt service. The debt service coverage ratio was approximately 0.4. That means the property was generating less than half of what it needed to pay the mortgage.
So how did this deal even happen? The lenders assumed rents would grow quickly as apartments escaped rent stabilization. They set up a $400 million interest reserve to cover shortfalls while they waited for rents to rise. Plus another $250 million in other reserves.
Then a New York court ruled that the landlords shouldn’t have been raising rent-stabilized rents to market rates while receiving certain tax benefits. Suddenly, all those optimistic cash flow projections fell apart. The reserves were nearly depleted. The rating agencies that had blessed the deal? They’d basically taken the lawyers’ word for it that the legal risk was no big deal. No further assessment of what would happen if those lawyers were wrong.
Chandan quotes a dissenting judge who referenced Cassandra from Greek mythology, the prophet cursed to never be believed. And that’s the irony. People in the industry called this out as a bad deal back in 2006 when it was announced. But those warnings were treated like background noise during the boom.
A $5.4 billion investment, built on aggressive assumptions, backed by securities that investors trusted because rating agencies said they were safe. And it all came apart.
Bank Lending Was in Its Own Mess
While everyone focused on CMBS, Chandan points out that banks had their own problems. The FFIEC (which includes the Fed, FDIC, and other regulators) released guidance in October 2009 encouraging banks to modify struggling commercial mortgages. The tone was basically: if you do reasonable modifications after proper analysis, we won’t punish you for it. Even if the restructured loans still look weak on paper.
But Chandan puts this in context. The FDIC’s own inspector general had found that the agency hadn’t responded aggressively enough to growing commercial real estate concentrations at certain banks. Some banks had incentive compensation programs that paid lending officials based on loan volume. Which is exactly the kind of structure that creates reckless lending.
And here’s something that really stands out. Back in 2006, regulators had actually tried to issue guidance about risky commercial real estate concentrations. The industry’s response? Over 4,400 comment letters, with the vast majority opposing the guidance. Industry associations argued that regulators should back off and that the lending environment was “significantly different” from the problems of the late 1980s and early 1990s.
It wasn’t different. It was worse.
Fannie and Freddie Were Bleeding
The government-sponsored enterprises were a whole other level of trouble. Fannie Mae reported a third-quarter 2009 net loss of $18.9 billion. Freddie Mac lost $5 billion in the same quarter after actually posting a small profit the quarter before.
To keep Fannie Mae from going into mandatory receivership, the federal government had to transfer $15 billion to the company. Total public commitment to Fannie Mae had reached $60.9 billion. Freddie Mac had received $51.7 billion. To put that in perspective, Chandan notes that Canada’s entire federal budget deficit for 2009 was smaller than the bailout given to either one of these companies.
And the dividend on the preferred stock the Treasury held was 10 percent. So Fannie Mae owed $6.1 billion per year in dividends to the government, which exceeded its annual net income in five of the past seven years. The lifeline was keeping them alive, but it was also making it nearly impossible to return to profitability. That’s a brutal catch-22.
The One Finding That Changes Everything
Here’s the part of this chapter that I think is genuinely important and often overlooked. Chandan’s analysis of bank-level data found something surprising.
Among the 5,015 banks with the largest commercial real estate exposure, there was no statistically significant relationship between how concentrated a bank was in real estate loans and its default rate. In other words, some heavily exposed banks were doing fine while others with less exposure were struggling badly.
What mattered wasn’t how much real estate lending a bank did. What mattered was how well they managed it. Risk management practices, accountability structures, and institutional decision-making separated the winners from the losers. Many well-managed smaller banks were actually in solid shape despite the headlines suggesting every bank was on the brink.
That finding cuts through a lot of the lazy narratives about the crisis. It wasn’t just about exposure. It was about how smart you were about that exposure.
My Take
Chandan’s chapter is the most academic one in the book, but it’s also the most honest. He doesn’t sugarcoat the government’s response. He doesn’t pretend the policy fixes were adequate. And he identifies the core problem that so many crisis analyses miss: the structures and incentives that caused the mess were never properly addressed. The fixes were mostly surface level.
The Stuyvesant Town story is a perfect case study of what happens when an entire market convinces itself that aggressive assumptions are reasonable. From the buyers to the lenders to the rating agencies, everyone chose to believe the optimistic scenario. The few people who spoke up were ignored.
And the finding about bank-by-bank variation in default rates? That’s a lesson that applies way beyond commercial real estate. Concentration in a sector isn’t automatically dangerous. Bad management of that concentration is.
Next post: Lenders Prepare for Impact
This post is part of a series retelling The Commercial Real Estate Tsunami by Tony Wood (ISBN: 978-0-470-63637-4). Chapter 5, “Bailing Out a Sea of Debt,” was written by Dr. Sam Chandan of Real Estate Econometrics.