Big Supply, Tight Spreads

A wave of commercial mortgage-backed securities hit the market in early March, following a dearth of issuance in January and February. Despite the volume, spreads over comparable Treasuries narrowed, perhaps reflecting pent-up demand.

But some analysts speculate that the narrowing spreads on CMBS reflect tighter spreads on residential mortgages, viewed by many investors as an alternative to loans on commercial properties.

Some $33 billion in issuance was on tap late February through March, reports Darrell Wheeler, a managing director with Citigroup. The market opened in March like a lion, absorbing several offerings led by issues from Wachovia, Citigroup, Bank of America and JPMorgan, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Fannie Mae joined the ranks of CMBS buyers in late February, taking down more than $826 million from an offering from Citigroup and Deutsche Bank. Fannie's arrival has allowed CMBS originators to structure huge classes previously known as the Freddie class (a reference to rival Freddie Mac), or the A-1-A tranche.

These tranches are essentially backed only by apartment loans. For example, a late February securitization by Wachovia featured an A-1-A tranche of $622 million, followed by a JPMorgan offering, which offered a $555 million tranche.

The competition between Freddie Mac and Fannie will surely tighten spreads in this class. But while Fannie's arrival was certainly appreciated by issuers, one trader noted the event was only “neutral to slightly positive” because the company intends to buy only bonds backed by multifamily loans, not the more generic triple-A issues.

Meanwhile, Freddie Mac in one day sold $2 billion in seven separate bonds. Last year Freddie, the largest CMBS owner, bought more than $15 billion in CMBS securitizations.

Gambling on interest rates

Most real estate developers don't possess a degree in economics, but that doesn't prevent them from forecasting interest rates. Although the 10-year Treasury yield is now approximately 4.75%, developers sense that rate increases are over and they aren't rushing to lock in interest rates. To the contrary, they are holding back for weeks at a time. Their track record has been good, so it's a fair bet the 10-year Treasury yield won't soon hit 5%.

Whenever two or more institutional lenders or CMBS buyers get together, the topic of loose underwriting standards always comes up. A salient part of the problem is the pervasive use of interest-only loans. Lately the number of such loans is declining, if only modestly.

In the fourth quarter of 2005, full and partial interest-only loans accounted for 64% of loans, down from a high of 68.5% reached in the second quarter, reports Fitch Ratings. But with pressure on lenders to book new business, the decline may not continue.

CMBS weathers the storm

Nearly seven months after Hurricane Katrina, it's becoming clear that although the storm resulted in personal and economic disaster for many, it had scant impact on the CMBS market, thanks to loan diversification. Immediately after the hurricane, Fitch Ratings identified 12 offerings for close scrutiny. Since then, the agency has reviewed five of the deals and determined that none were hurt by Katrina losses — and it doesn't expect the remaining seven to suffer, either.

Meanwhile, hotel loans have enjoyed heavy demand. Merrill Lynch reports that they accounted for almost 11% of total securitizations last year, up sharply from 2.4% in 2002, and so far this year they account for a 12.6% share.

The wider spreads on hotel loans make them profitable for conduit originators. Institutional lenders and CMBS buyers are attracted by the sharp drop in loan delinquencies. In June 2004, some 4.5% of hotel loans were delinquent. Last month that number had fallen to 1%.

To be sure, hotels react more quickly to changing economics because rooms are taken for only 24 hours at a time. But for now, investors are solely focused on the improving financials.


Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 3/6/06 2/6/06
AAA 78-79 80-81
AA 93-94 99-101
A 103-104 108-110
BBB 152-157 167-172
BB 300-325 315-340

Whole Loans*(Interest Rates)
Mtge. Range
Mtge. Range
Term of loan 3/6/06 Rate 2/6/06
5 years 5.70-5.80% 5.75% 5.55-5.65%
7 years 5.70-5.80% 5.75% 5.60-5.70%
10 years 5.72-5.82% 5.77% 5.66-5.76%
For loans of $5 million and up, on amortization schedules of 25-30 years that can be funded in 60-120 days with 0-1 point.

*In basis points, or hundredths of a percentage point.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.

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