Losses on Mervyns-Backed Bonds Could Get Grimmer

By PRABHA NATARAJAN When Mervyns, a California-based department-store chain, filed for bankruptcy protection in July, the nearly $1 trillion market for commercial mortgage-backed securities barely blinked. Now, investors are anxious to see just how bad the losses could be on the $2 billion of bonds backed in part by Mervyns's commercial real-estate loans since it could also serve as a template for debt tied to bankruptcies of other struggling retailers. Many retailers are discovering that they won't be able to survive a protracted recession. Instead of restructuring their debt to stay solvent, retailers such as Mervyns and most recently Circuit City Stores have opted to liquidate. This means that the outlook for commercial real estate is far grimmer than investors thought a few months ago, and losses are likely to be greater and felt much faster than initially expected. Mervyns, the first large retailer to complete its liquidation in this business cycle, no longer exists. As a result, investors holding bonds exposed to the department stores could see interest, and even principal payments, decline immediately if the empty stores don't find new occupants. "It's hard for a retail property to show cash flow or cover debt-service obligations when the main occupant is gone," said Frank Innaurato, managing director of CMBS analytical services at Realpoint. For investors in layered commercial real-estate bonds, that's not good. Securitized bond deals like those backed by Mervyns's loans are sliced into various portions based on risk. The lower-rated portions are the first to suffer losses should income streams slow. Barclays Capital estimates that the lowest, unrated portion of the bonds exposed to Mervyns will be wiped out as well as the double-B-minus portion. In the current environment, there's little chance of finding another occupant for these big-box stores with thousands of square feet of space, analysts say. What makes the situation even more of a challenge is that many of Mervyns's stores are located in some of the nation's most depressed housing markets such as California, Nevada and Arizona. Still, earlier this month, Developers Diversified Realty and Macquarie Bank of Australia, which are responsible for paying off some of the Mervyns commercial real-estate loans, said they planned to lease five of their 38 unoccupied stores to Kohl's Department Stores, following an auction of leases held in December. Developers Diversified Realty, Macquarie Bank and Inland Western Real Estate Trust bought some of Mervyns's property from a group of private-equity firms that owned the department-store chain in 2005 when unlocking the value of real-estate holdings was in fashion. Investors worry that the economic downturn's impact on the retail sector is likely to last well into this year and next, as consumer spending is expected to pick up only after the housing crisis is resolved. "We believe that continued weakness in this sector will likely cause more retail loans to underperform, which would trigger increased delinquencies and could ultimately translate into more retail-related downgrades," wrote Larry Kay and James M. Manzi, analysts at Standard & Poor's, in a report.