Yield Spreads Reverse Course

In a classic case of having gone “too far, too fast,” the yield spreads on commercial mortgage-backed securities (CMBS) returned from the extraordinarily low levels they had briefly reached, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Spreads on long-term triple-A CMBS widened during the last week in February to as much as 0.45 of a percentage point over interest-rate swaps, after dropping into the high 0.30s. And there were some signs of further spread increases in the offing. The best explanation is that an overdue market correction has occurred with regard to yield spreads.

According to Darrell Wheeler, director and head of CMBS Research at Salomon Smith Barney, new fixed-rate CMBS issues were ready to go in March, totaling $9 billion. But analysts generally doubt that long triple-A spreads will hit 0.50 of a percentage point, even with the coming volume.

The commercial mortgage business continues to benefit from ever-larger allocations by lenders, who have been put off by each new corporate credit scandal. In late February, news of accounting irregularities at international grocery conglomerate Ahold NV became the latest in a long series of disappointments on the corporate landscape.

Brutally Competitive

But just as lenders find themselves flush with cash, originations are starting to sputter. As one lender put it, “It's brutally competitive in the originations business.” If the lack of new loan originations continues, one player suggested, some lenders will be “sorely disappointed with their loan production by year-end.” The slowdown may be war-related or the result of deterioration in real estate fundamentals.

In late February, the third fixed-rate conduit transaction this year came to market in the form of a $1 billion offering from underwriters led by Credit Suisse First Boston. More than 30% of the collateral was multifamily loans, which always attract an enthusiastic following.

Though some investors groused that the asset quality was “not the sweetest” and that the leverage was above their comfort levels, buyers flocked to the short triple-A Class A1; the order volume was three times the available bonds.

The A1 class was priced to yield interest-rate swaps plus 0.39 of a percentage point, while the A2 class was priced at swaps plus 0.43 percentage points — on the tight side of expectations. The triple-B class G didn't fare as well with a final price of swaps plus 1.32 points vs. market guidance of swaps plus 1.25 to 1.30.

Investors are not alone in their complaints about “leverage creep.” They have plenty of company from their guardians at the rating agencies. According to Tad Philipp, managing director of Moody's Investors Service, the loan-to-value ratio on generic conduit transactions rose to 89.6% during fourth-quarter 2002, the highest level recorded since the study was started in 1998.

As might be expected, these calculations differ from Wall Street's; the investment banks bringing the transactions to market always show significantly lower loan-to-value ratios.

Moody's also noted that the number of loans with greater than 100% loan-to-value has now increased to 6% of conduit volume from 2%, the highest level since 1999.

Unique Offering Comes To Market

In early March, Goldman Sachs was scheduled to bring to market a $1.5 billion securitization that is being watched closely.

Rather than a standard conduit transaction with lots of small loans or a standard fusion transaction, with a bevy of small conduit loans and a few large loans, this pool is filled with large loans and a relatively small number of conduit-type loans.

The 10 largest loans in the transaction make up some 63% of the portfolio. As one buyer says, “It's an extremely chunky offering.” Additionally, some 57% of the loans are either interest-only or have some interest-only period, so there will be only a small amount of amortization.

As one analyst pointed out, this securitization features the dual trend of both rising leverage and falling diversity, which “leaves no room for error.”

More than a few CMBS buyers and traders are watching to see how it is priced.

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 3/03/03 2/03/03
AAA 84-86 86-87
AA 94-96 95-97
A 104-107 107-108
BBB 171-176 169-174
BB 450-475 450-475

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 3/03/03 Rate 2/03/03
5 Years 4.56-4.66% 4.61% 4.89-4.99%
7 Years 5.12-5.22 5.17 5.46-5.56
10 Years 5.49-5.59 5.54 5.82-5.92
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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