Could the Subprime Mortgage Meltdown Become Contagious?

The news continued to go from bad to worse on the residential mortgage front in late March. A Federal Reserve official testified before the House Financial Services Committee in Washington, D.C. that borrowers of subprime mortgage loans will experience more delinquencies and foreclosures over the next one to two years. It's estimated that subprime loans accounted for one-fifth of all home loans in 2006, or about $600 billion, according to media reports.

To what degree will the subprime debacle affect commercial real estate lending? “There has been some spillover, and to some extent it's just sort of a fear factor,” says Clay Sublett, CMBS director and senior vice president with KeyBank Real Estate Capital. “Commercial real estate has had such a good run. Particularly in CMBS, anytime there is a hiccup investors get nervous.”

Case in point: In a recent $4 billion securitization led by Merrill Lynch in which KeyBank contributed about $560 million of loans to the fusion deal, spreads in the 10-year Triple-A tranche widened by two basis points as the deal was being priced. Almost overnight, investors demanded a higher return in the wake of the subprime scare. That's significant because the Triple-A tranche typically accounts for about 85% of a securitization. Since that deal, the gap in spreads has narrowed to previous levels, dropping two basis points.

“There is an immediate negative reaction, but over a reasonable time you get a sanity that returns to the marketplace,” observes Sublett, whose CMBS shop at KeyBank in Kansas City is on track to generate $3 billion in volume in 2007, up from $2.2 billion in 2006. That growth is linked to the fact that commercial real estate fundamentals remain strong. Sublett believes the subprime mortgage implosion could lead to tighter underwriting standards for commercial real estate, a positive sign, but otherwise it will have “a negligible effect.”

Stock investors also have exhibited some jitters. The stock price of HFF Inc. (NYSE: HF), a dominant commercial mortgage brokerage, recently dipped 29% over a six-week period. HFF (previously Holliday Fenoglio Fowler) went public Jan. 31. After reaching a high of $21.35 on Feb. 2, the share price fell to $15.16 on March 13 before recovering somewhat to $16.05 by March 27.

“The stock has pulled back recently on concerns related to the global equity market correction and possible contagion from residential subprime lending woes,” wrote Morgan Stanley analysts in a March 12 research note. That global correction analysts are referring to was set in motion on Feb. 27 when the Shanghai stock market plunged 9%, sending stock indexes tumbling across the globe.

“We believe there is significant risk attached to a sustained widening of spreads in the bond market,” the analysts added, “which could shut down liquidity in the capital markets, as occurred during the Russian debt crisis [in 1998].”

Let's hope the industry doesn't have to relive that painful memory.

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