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CMBS Market Throttles Down

Prepare for a much leaner and meaner commercial mortgage-backed securities market in 2008. Domestic CMBS issuance this year is expected to drop by more than 50% to $108 billion, down from a record $223.8 billion in 2007, forecasts Commercial Mortgage Alert, a weekly newsletter that covers the bond industry.

Even if The Blackstone Group completes a planned $9 billion CMBS offering backed by Hilton Hotels in the first quarter, total issuance is expected to pale in comparison to recent years.

Sources also expect loans to face increasingly stringent underwriting standards. In short, borrowers will encounter smaller loan proceeds and higher costs.

Issuers are already contending with increased subordination levels, forcing them to pay higher yields to bond holders at every level of the CMBS capital stack to compensate for heightened risk. The tumult led Citigroup research strategist Darrell Wheeler to write in December that CMBS originations could be entering “a long issuance hibernation period.”

One factor that would keep issuance at bay is widening spreads, which rocketed from 73 basis points over the swap rate on Aug. 15 to an all-time high of 125 basis points on Dec. 5.

“As we enter the new year, we suspect spread volatility will remain elevated and issuance volume will decrease significantly for at least the first half of the year,” says JP Morgan CMBS analyst Alan Todd.

“Investors will likely show a strong preference for deals with more conservatively underwritten collateral,” adds Todd. That would include loans without interest-only periods and with loan-to-value ratios around 75%, for example.

Relatively few deals have been priced of late. CMBS issuance in October totaled only $6.3 billion, an 84% decline from March when $38.5 billion was issued, according to Commercial Mortgage Alert.

Lower issuance also has hindered new acquisitions. When the market was hot, competitively priced CMBS enabled many borrowers to finance deals at very low interest rates. In fact, CMBS helped finance roughly 40% to 60% of all commercial property transactions between the end of 2003 and 2006.

Even AAA-rated mortgage bonds have fallen out of favor in recent months. “There are definitely lots of babies getting thrown out with the bathwater today,” says Spencer Haber, CEO of private real estate securities firm H/2 Capital Partners in Stamford, Conn.

Todd says that lenders will continue to purge their balance sheets of aggressively underwritten loans that were originated in 2007, and fewer aggressively underwritten loans have been issued since the summer. Amortization is virtually a requirement now and 90% financing is a rarity.

“The new issuance of CMBS has really slowed down to a dribble,” says Clay Sublett, CMBS director and senior vice president at KeyBank Real Estate Capital in Cleveland. “It's pretty scary when there are no buyers for so many tranches.”

Even fewer buyers are angling for commercial real estate collateralized debt obligations (CRE CDOs). Karen Trebach, senior director at Manhattan-based Fitch Ratings, says there haven't been any CRE CDOs issued in recent months.

The collateral backing CDOs is “definitely riskier” than CMBS collateral, notes Trebach. Even so, few borrowers are falling behind. Delinquencies on commercial real estate loans in CDOs ticked up to 0.15% in November from just .08% at the end of October, reports Fitch.

Fitch expects CMBS defaults to reach 1% by year-end 2008, a miniscule rate. Yet many observers expect it to inch upward in coming years now that debt is less readily available to bail out troubled loans.

Wheeler of Citigroup believes the recent run-up in spreads is temporary. “There is one thing we are sure of,” he writes. “By February, steady real cash demand will tighten these spreads.” The securitization world is hoping he's right.

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