Picking the winners in the CMBS sweepstakes

Commercial mortgage rates were jolted sharply higher at the beginning of the summer, according to the Barron's/John B. Levy & Co. National Mortgage Survey of more than 30 participants in the commercial mortgage-backed securities and whole-loan markets. The rate increase brought about by inflation fears pushed many borrowers to the sidelines as they chose not to take the new higher rates and lower loan proceeds.

Despite many pessimistic forecasts, CMBS issuance volume for the first half of 1999 turned in a more than respectable performance at $34.5 billion. Although the first half of 1998 saw significantly higher levels, this year's volume was the second highest on record. Earlier this year we asked a group of market participants for their AAA spread and volume forecasts for the first six months. Rob Cestari, vice president at Nomura, was the volume winner with his projection of $35 billion, while Haejin Baek, senior vice president at Lehman Brothers, projection of a 125 spread was closest to the 121-124 AAA spread shown in the table below. We invited the winners back along with a new group of participants and asked for their AAA spread and volume forecast for the second half of this year (refer to NREI Insider, page 8).

Most of our market forecasters noted that, on a technical basis, the real estate markets - CMBS in particular - seem to be in good shape. Loan default and delinquencies are at an all-time low, and most real estate markets do not suffer from overbuilding. But the Y2K problem is on everybody's mind, with thoughts ranging from near calamity to those who are calling it the "big snooze."

These comments aside, most market participants cautiously anticipate the fourth quarter and want to make sure that they have liquidity available for buying opportunities should serious spread widening occur. The Y2K issue does not seem to be so much a domestic problem, but rather a concern about whether foreign countries are up to speed. Some analysts pointed out that Southeast Asia's problems did not take long to wash ashore here.

With Y2K in the background, some originators are trying to cram second-half production into the third quarter and early fourth quarter. As a result, there is precious little supply planned for November and December. But by cramming new issuance into a short time period, the deal calendar could become lumpy, forcing spreads to widen quickly if several securitizations come to market at one time.

On a positive note, CMBS joined the Lehman Brothers' Aggregate Bond Index on July 1. Fixed-income money managers who are benchmarked to the Lehman Aggregate now will need to include CMBS in their portfolio or risk being out of sync with the index. In late June, Merrill Lynch announced that it too was joining the CMBS index crowd with five new CMBS indexes intended to bring liquidity to the market and allow money managers and originators to hedge CMBS portfolios.

The second quarter CMBS calendar kicked off with a new $810 million securitization from General American Life Insurance Co. The transaction is being underwritten by a group led by Morgan Stanley and is showing, at 19%, record subordination levels to the AAA tranche, reflecting the quality of the originations and the fact that many of these loans are well seasoned. Some money managers gripe that the ratings agencies, in an effort to gain market share, seem to be willing to offer lower subordination levels, which provide less protection for the AAA tranches. Others note that Wall Street underwriters have become more skilled at assembling loan portfolios that minimize risk to potential securities buyers.

It is not a pretty sight on the orignination side. Originations declined significantly with most conduit originators doing 50% or less of the volume that they intended. On the insurance company side, the environment is a bit more positive. Most insurers have been able to meet their target originations for the first six months but note that their pending list is, as one institutional manager noted, "shrinking by the day." The Federal Reserve's announcement that it is taking a neutral stance with respect to further rate increases may bring some interest rate stability to the market and entice borrowers back into the loan markets.

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