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Standoff in Secondary Markets

There has been a deafening silence in the secondary trading pits for commercial real estate-backed loans over the past two months. This comes as investment banks — usually center court for these activities — are still digesting the sudden collapse in the once fledging commercial loan trading sector.

To be sure, the overnight flight of liquidity in the residential space has played a major role in creating this standoff as the drying up of the liquidity spigot casts a dismal pall of concern over investors, deal intermediaries and commercial loan originators.

In turn, this concern is causing real estate deals to be canceled left and right, lenders to rethink the appraisal value of commercial buildings, and investors to demand higher compensation for assuming what they now perceive as more risk.

In particular, high-leverage deals are experiencing the greatest amount of execution uncertainty and challenges, as skittish mezzanine, B-piece, and other high-risk investors demand better compensation for taking on more risk.

The significant drop in CMBS volume during the closing days of the third quarter also aroused angst among these investors, causing many market observers to slash their forecasts for CMBS and commercial real estate CDO volume for the fourth quarter.

Dramatic drop in issuance

In a recent conference call to its issuer, broker and investor members, the Commercial Mortgage Securities Association (CMSA) conceded that CMBS and commercial real estate CDO volume for the fourth quarter will be a mere shell of the volume tallied in the first three quarters.

Fixed-rate deal volume for 2008 is expected to drop to between $80 billion and $100 billion, while floating-rate issuance may be just $15 billion to $20 billion, according to CMSA members. These numbers are paltry compared with the combined volume of $205 billion in 2006, and an estimate of over $210 billion for 2007.

But consider that total U.S. CMBS issuance in September fell a whopping 72.5% from August's level, to just $8.2 billion from $29.9 billion, according to Commercial Mortgage Alert. Volume also plummeted 64.8% compared with the same period in 2006, when the market saw issuance of $23.4 billion.

So how might this standoff in the secondary markets be resolved? And can the stalemate precipitate a major decline in commercial real estate transactions?

To begin with, lenders and investment banks holding loans originally slated to be packaged into CMBS or CDO deals now find themselves holding these positions as portfolio lenders and investors.

The assets simply cannot be adequately valued for trading in the open market. These institutions must hold the loans as balance sheet items, or dispose of them in what is now largely a marketplace of distressed debt buyers.

Holding out for more

Today, the originators and loan aggregators who have strong balance sheets may very well wait out these distressed-loan investors, as dealers continue to report a distance of as much as 10% between the bid and asking prices for recently originated fixed- and floating-rate loans.

Many investment banks and lenders so far have resisted pressure to sell loans at steep discounts. Ultimately, either bidding investors will be forced to move closer to the terms of lenders, or some lenders will begin to face margin calls on borrowed funds, forcing them to liquidate positions in a bidders' market. Stay tuned.

Meanwhile, the building owners and investors who depend on the secondary markets to fund their deals are faced with rising borrowing costs and declining real estate values — a lethal combination that offers the greatest reason for concern among market observers.

If the standoff between holders of loans and investors continues much longer, borrowers will pay the consequences, and a significant real estate correction could be in the offing.

On the other hand, if the stalemate is broken, then the pipeline of capital to both purchase real estate assets and to fund the borrowing needs of deal principals will surely start to flow in relatively short order.

Ultimately, if the stalemate is resolved quickly enough, both lenders and secondary market traders will have finally discovered the elusive value that the marketplace is willing to place on existing loans. Only time will tell.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.

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