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Will the Loan Trade Market Finally Open Up?

For some time now, there has been a virtual standoff in the real estate loan investment and trading marketplace. Investors with access to capital have been vying to win deals from banks and other lenders with little success.

The differences between bid and ask prices have been so wide that the market for whole loans has been shuttered for the past six months, starving for a flow of loans to get it jump-started. And this lack of product flow has led both the residential and commercial mortgage-backed securities business to suffer the same fate as loan portfolio trades — virtual inertia.

Potential deals have not been undertaken because any attempt to do so in this stalemate environment would likely result in losses to sellers and securities issuers. Many sellers have already been taking hits by writing down the value of their loans, with the hope of having some recovery upon disposition.

And with a few loan trades now beginning to emerge — mostly in the residential arena — there may be reason to believe the stalemate is about to be over.

Private equity reigns

In a recent deal, private equity firm BlackRock agreed to purchase a residential mortgage portfolio from UBS Securities at a significant discount. BlackRock acquired the portfolio that UBS valued at $22 billion, at a price of $15 billion, representing a trade of 68 cents to the dollar.

UBS had already written down the portfolio by $37 billion during the first quarter, and many in the industry believe the finalization of this deal will represent a market-clearing price for others to follow. This deal is significant enough to possibly send the signal that skittish sellers are finally prepared to meet distress and opportunity buyers halfway.

Until recently, banks and lenders had been quite reluctant to make trades because they were unwilling to take sizable actual losses, expecting a recovery from the steep loss in value that has been piling up since last summer. However, the need to raise capital while writing down existing loans may be the driving force behind the banks' willingness to negotiate.

Here's the critical question: When will this loan trading activity reach the commercial real estate marketplace? The answer to that question may yet rest with the private equity firms themselves, as well as the real estate hedge fund managers. These firms and fund investors have been kicking the tires on commercial mortgage loans — particularly small-balance deals of $10 million and under — for the past few months, with no major trades being announced.

This suggests that banks and lenders holding commercial mortgages are not yet willing to sell at significant losses. Commercial loans, even small-balance ones that track residential to a large degree, are generally expected to perform better than residential. So lenders have not written down their commercial real estate portfolios — at least not yet.

Regulators force banks' hand

One of the major reasons commercial banks — and investment banks in particular — are forced to the negotiating table of loan sales is the need to sure up their financial structures. Indeed, regulatory agencies have been quite vocal about the need for financial institutions to sure up their capital base, and pare back their holdings of real estate loans.

These regulators have also made it clear that the institutions — especially those with deposits that are insured and regulated by the agencies — need to enhance their risk management capabilities and reorganize their operating business to avoid falling out of compliance with capital requirement ratios or other safety and soundness guidelines.

Meanwhile, the real estate loan origination business has been dormant, pending both the clearance of loans from lenders' balance sheets and the reopening of a secondary market as an outlet for any new originations. So one can be sure that when lending does resume, loans will be underwritten with strict guidelines to attract secondary market buyers and to put loan investors at ease.

But the disconnect is that much of the funds raised in recent months are being directed at high-yield opportunities. This is clearly the motivation of BlackRock in its UBS deal. BlackRock's most recently closed real estate fund raised $3.3 billion in the first quarter of 2008 alone, with another $23 billion reportedly in its investment pipeline. To date, however, not much product has emerged in the commercial world for this high-risk investment capital.

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


Tightening spreads show sellers' willingness to take discount losses.

10-yr fixed-rate (conduit) 5/14/08 Week earlier 52-wk. avg.
AAA S+158 S+170 +126
AA S+575 S+600 +317
A S+775 S+800 +433
BBB T+1,487 T+1,511 +786
BB T+2,300 T+2,300 +1,014
B T+2,700 T+2,700 +1,364
S=fixed- to floating-rate swap
T=10-year Treasury Source: Morgan Stanley
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