Summer Surprise

Securities backed by commercial mortgages took a licking and kept on ticking in July. In a tumultuous Treasury market, 10-year yields jumped 75 basis points, or three quarters of a percentage point, in two weeks. And in an equally turbulent market for interest-rate swaps, spreads over Treasuries widened some 18 basis points in the same period.

Yet all this failed to roil the commercial-mortgage market, according to the Barron's/John B. Levy & Co. National Mortgage Survey of market participants. In fact, 10-year, triple-A spreads over interest-rate swaps, at 35 basis points, have traded within a range of one to two basis points for 14 straight weeks, according to Morgan Stanley. Securitizations of commercial mortgages, unlike those for mortgages on single-family homes, are protected from early prepayments by stringent penalties.

To be sure, the sharp rise in Treasury yields — the largest two-month selloff since Citigroup began collecting data in January 1990 — caught many borrowers flat-footed. Some were lucky enough to lock in rates early in the process, but many others were on vacation and unable to react in time. And higher Treasury yields affected the pace of loan originations as borrowers try “to figure out how real these new higher rates are,” says Ken Cohen, vice president with Lehman Brothers.

Testing the Market's Liquidity

Liquidity continues to be high in the secondary market for commercial mortgage-backed securities. In late July, a Merrill Lynch unit that was once a significant acquirer of triple-A CMBS sold six offerings for $360 million to a hungry market.

The previous week, Freddie Mac sold a $650 million offering of multiple securitizations to a number of eager Wall Street dealers. It was the first sale ever by Freddie, which with 8% of the market is the sector's largest buyer. The sale also passed the word to buyers that the sale was unrelated to the Freddie Mac's current accounting problems.

Some observers wondered, however, whether management was testing the liquidity of the Freddie CMBS portfolio. Wall Street generally seemed to accept Freddie's view. In fact, spreads on practically every issue were tighter than market levels had been before the sale. Freddie Mac officials were unavailable for comment.

Major Offerings On the Way

The CMBS new-issue calendar continues to be chockful with offerings. General Electric and J.P. Morgan Chase priced securitizations during the last week in July, and no fewer than four major offerings were scheduled for August, a notoriously quiet month.

Also in late July, GE brought a $1.1 billion offering to market with collateral consisting of 138 fixed-rate loans. The Class A-4, rated triple-A, traded at a spread of 34 basis points over swaps, the tightest level since the hedge fund, Long-Term Capital Management, collapsed due to the Russian bond default crisis in 1998. The offering also included a $283 million class A-1A rated triple-A, which market sources indicated was sold in its entirety to Freddie Mac. The purchase seemed to confirm that Freddie was not backing away from the CMBS market.

Corporate Bonds Win Big

Mortgage loans on commercial properties showed a 3.26% total return in the second quarter, according to the Giliberto-Levy Commercial Mortgage Performance Index. Lehman Brothers' investment-grade CMBS index posted a 3.67% total return as individual loans and the securities benefited from tightening spreads.

But corporate bonds were clearly the big winners; corporate spreads tightened more than those of commercial mortgages. The Lehman Brothers' duration-adjusted triple-B corporate index returned a strong 5.14%.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2003.


Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 8/4/03 7/7/03
AAA 91-92 71-72
AA 98-99 78-80
A 105-107 86-88
BBB 151-156 131-135
BB 425-440 425-440

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 8/4/03 Rate 7/7/03
5 Years 4.96-5.06% 5.01% 4.12-4.22%
7 Years 5.33-5.43 5.38 4.55-4.65
10 Years 6.03-6.13 6.08 5.13-5.23
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

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