Decision may derail mortgage-backed securities

Interest rates on commercial mortgages remained fairly stable during the last 30 days, though Treasuries seemed to bounce around with no particular pattern. Spreads -- the difference between mortgages and Treasuries of the same term -- continue to be under downward pressure, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

The big story this month deals with neither interest rate increases nor spread declines, but with a possible major derailment in the heretofore burgeoning commercial mortgage-backed securities market. In late 1993, Taubman Realty Group, an equity shopping center real estate investment trust traded on the New York Stock Exchange, floated an $88 million single-asset securitization through Goldman Sachs. This mortgage-backed security was collaterized by a first mortgage on Lakeside Mall, which is located in a suburb of Detroit. The offering was heavily oversubscribed. Because the bonds were rated "AA" and sold under the terms of rule 144(A), insurers who bought this seemingly attractive security sought to include it under their list of securities. The National Association of Insurance Commissioners (NAIC) has now decided that this securitization should be reserved for as a mortgage and not as a security, a decision requiring insurers to reserve 10 times more capital. Calls to the NAIC confirm that they have made this decision but they declined to give any justification, explaining that their ratings are a private matter. Private matter or not, the ruling has left the CMBS market in an uproar. Major insurers are unwilling to purchase more of these securities until they find out exactly how they'll be classified and, thus, what the risk-based capital requirements are. In late November other institutions were busily trying to sell some of their existing mortgage-backed securities before the announcement became widely known.

In the conventional loan market, the story continues along familiar lines. Too much money chasing too few deals. Both spreads and underwriting are continuing to reflect that trend. The Barron's/Levy 10-Year Prime Mortgage Spread, which was under attack all of last year, is down another notch to 1.5%. And for particularly well-managed deals, that's only a starting point. A few survey members moaned openly about losing low leverage loan opportunities at spreads as low as 1%. For trophy transactions, several survey members have even offered to pay all of their borrower's closing costs in order to encourage the borrower to accept a loan from their institution.

The flood of money in the commercial mortgage business comes as no surprise since the asset class is performing so well. For the third straight quarter, the Giliberto-Levy Commercial Mortgage Performance [] significantly outperformed the Lehman Brothers "Baa" Medium Term Bond Index. The third quarter Giliberto-Levy "flash index" of 1.94% outdistanced the Lehman Index, which shows a return of 1.39% for the same period. In the first and second quarters, mortgages outperformed bonds by an even greater difference. For the first quarter, mortgages outperformed bonds by 3.53%, while in the second quarter that difference declined to 2.36%.

In an attempt to gather more commercial loan business, a number of large survey lenders are showing an increased willingness to consider a broader range of property types. Hotel loans are clearly hot these days, even though they have shown more pro rata losses than office buildings. Also on the expanded list are miniwarehouses, nursing homes and mobile home parks. Though mobile home parks are often thought as highly risky, the facts seem to show that these are extraordinarily safe investments, especially when populated by retirees in the Sun Belt area. In a further attempt to corral business, institutional lenders are occasionally agreeing to commit loans for delivery up to 12 months in the future ... for rate premiums that may be as little as 1/4% above their best immediate delivery rate.

The large slowdown in fund raising in the REIT market has caused capitalization rates to increase markedly. Apartment cap rates are up at least .5% recently, thus reducing the price that buyers are willing to pay. For the most part, survey members did not use super-low cap rates for lending purposes, so the rather large rise has not endangered any of their multifamily loans. A rising interest rate market and a continuing drought in the REIT market should put continued upward pressure on capitalization rates.

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