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Euphoria on the investment front

Commercial mortgage rates were jolted out of their seemingly inexorable downward spiral last month, according to the Barron's/John B. Levy & Co. National Mortgage Survey of large institutional lenders nationwide. The Barron's/Levy 10-year prime mortgage rate, which hit a low of 7% in early February, was 5/8% higher as March began. This sudden, forceful rise in interest rates caught many borrowers asleep at the switch. Their optimistic nature had led them to believe that further declines were inevitable, but it was not to be.

The long-awaited Confederation Life Insurance Co. commercial mortgage backed securities (CMBS) offering came to market just before interest rates lurched northward. The offering - the largest private CMBS deal ever - consisted of 564 loans originated by the U.S. branch of the Canadian insurer, which is now in rehabilitation. Underwriters, led by Lehman Brothers, brought this $1.6 billion multiclass transaction to a market which could best be described as superheated. Industry sources noted that the underwriters had subscription requests for 10 times the face amount of the securities and, as a result, virtually none of the investors received as large an allocation as they would have liked. Approximately 85 investors, led by the mutual fund giant Fidelity, Metropolitan Life and New York Life, fought to get enough allocation. In fact, the bidding was so frenzied that a number of survey members were able to sell their allocation for a profit on the very same day. Insiders noted that two mutual fund groups actually offered to buy the entire transaction!

Investors were particularly excited about this transaction in no small part because of its size, which assured a future liquid market. Not only are the underwriters making a secondary market in the securities, but other firms such as Morgan Stanley have also geared up to insure that secondary market transactions can be efficiently handled.

The two senior classes labeled A-1A and A-1B were particularly sought-after since both tranches were rated AAA and carried a relatively short life of 1.32 and 2.37 years. This strongly appealed to money managers who viewed the pricing for these tranches at 65 and 75 basis points over Treasuries as offering real value for such highly rated, short-term collateral.

Not to be outdone in euphoria, the Mortgage Bankers' Association of America held its annual Commercial Mortgage Banking Conference in San Diego just after the Confederation Life deal was priced. The meeting attracted a record attendance of more than 3,200 registered delegates and an unknown number of "hangers-on." Based on chart-topping levels of loan production in 1995, bankers and their lenders were in a heady mood with projections of an equally successful 1996 emanating from each meeting. The gathering convinced most lenders that there is a great deal of institutional money available this year and, as a result, lenders can expect intense competition. The good news is that most institutions have set production goals for 1996 which are reasonable and don't require heroic amounts of production. In many cases, 1996 goals are significantly below actual 1995 production levels. By setting reasonable production goals, institutions are hoping to bring continued stability to the underwriting process.

In spite of the large number of lenders soliciting new transactions, a few observers predicted that commercial mortgage spreads - the difference between mortgages and Treasuries of the same maturity - would actually increase by 25 to 35 basis points this year. They reason that this will bring them more into line with CMBS spreads. They add that though there is ample money available now, there will be more than enough deals soliciting capital which will tend to drive spreads a tad wider. On a cautionary note, several survey members noted that the number of guaranteed investment contract owners choosing to change from fixed income programs to stock market equities has more than doubled over expectations. If this continues, there will be a cutback in the allocations to commercial mortgages, which would make a spread increase even more likely.

Regional shopping malls, those giant 1 million sq. ft. or more malls anchored by several department stores, are coming in for some recent scrutiny. In the past, loans on these assets have performed almost without a glitch. But retailers are having trouble paying the high rent, and there is intense competition from the Wal-Marts of the world for the consumers' dollars. A few mall lenders have become a bit more cautious and have decided to offer loans on malls only where the loan to value is at 60% or less.

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