Stock market crash stops deals, widens spreads The stock market crash and subsequent rebound in late October left the commercial mortgage market with higher spreads and lower rates, according to the Barron's/John B. Levy & Co. National Mortgage Survey of major whole-loan and commercial mortgage-backed securities (CMBS) buyers. For a few days, CMBS trading virtually ground to a halt as traders waited to see where corporate bond spreads would settle. As a result, the week saw no new deals come to market.
Just one business day before the stock market crash, Nomura Securities priced a huge $1.76 billion transaction known as D-5. The security consisted of both large loans -- those with balances of more than $25 million -- as well as garden-variety conduit loans. This hybrid structure, better known as a "fusion" deal in the trade, was well received, especially given the considerable supply of pending deals in the market and the nervousness caused by the so-called Asian flu. The large 'AAA'-rated A1-C tranche, which comprised some $740 million, carried a spread of .72% over the Treasury curve, while the A-5 tranche rated 'BBB' was priced at 1.0% over. After the deal was priced, spreads seem to have widened significantly in the secondary market, such that some of the A1-C tranche bonds were being re-offered at a spread of .78% to .80%.
The market jitters have not only caused spreads over Treasuries to widen, but bid/ask spreads to widen as well. Until recently, mortgage traders priced 'AAA'-rated bonds with bid/ask spreads in the .02% to .03% range. Market anxieties have now ballooned that to .05% to .07%.
The CMBS market is headed for yet another record year with 1997 transactions expected to total in the $37 billion to $38 billion range -- fully 20% higher than the previous record set just last year. On the pending list are transactions which will total $11 billion, and both market buyers and sellers are wondering how far spreads will have to widen to sell this large amount of new product. According to one money manager, the market is clearly going to have a "digestion problem," while yet another sees this as a striking opportunity to buy selectively and pick up additional spread in the process. Both buyers and sellers seem to agree that by first quarter of 1998, when new allocations are available, spreads will begin to tighten and a more normal CMBS market will evolve.
Some major CMBS buyers and traders are suggesting that there will be a good deal of "trading on swap" before year's end. This occurs when dealers entice their CMBS clients to buy a new issue by agreeing to simultaneously buy an existing security from the buyer in order to enable him to make the new trade. "Trading on swap," though not unheard of in the corporate bond market, hasn't been seen much during the last three years of the CMBS market as CMBS bonds have heretofore been in short supply.
On the whole-loan side, institutional lenders can hardly mask their sense of glee at the dramatic spread widening occurring in the CMBS market. They are quick to point out that the widening CMBS spreads will make their whole loans more acceptable to borrowers. Several larger players noted that they were actively quoting new transactions even at the depth of the equities crash while most CMBS firms were on the sidelines waiting for the storm to clear.
In order to keep their average yields high, and yet still compete for loans which require a low spread, a number of institutions are investing in whole loans with a so-called "barbell" approach. On one hand, they are willing to chase deals with spreads below 1.0%, especially if they sport a low loan-to-value or can be combined with a strong corporate credit. Simultaneously, they are looking for higher spread transactions so that a reasonable average spread level can be maintained. On the high spread side, the asset class of choice seems to be hotels, even though that asset class wreaked havoc during the recession of the early-'90s.
The continuing high interest in commercial mortgages is in no small part a reflection of their strong performance. During the third quarter, commercial mortgages again outperformed the duration-adjusted version of the Lehman Brothers Baa bond index by a return of 3.67% to 3.54%. Private placement corporate bonds showed a total return of 3.36%. Meanwhile, delinquency and default losses are virtually disappearing with the Giliberto-Levy Commercial Mortgage Performance Indexsm recording its best results since the third quarter of 1986. Losses on apartment loans totaled a virtually nonexistent .10% from Sept. 30, 1996 to Sept. 30, 1997!
Comments and questions are welcomed at www.jblevyco.com.
John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va.