Spreads tighten as volume slows

The commercial mortgage business fared well this summer, according to the Barron's/John B. Levy & Co. National Mortgage Survey of more than 30 institutional investors involved in both individual mortgages and commercial mortgage-backed securities (CMBS). Both whole-loan and CMBS spreads tightened modestly, caused in part by the lack of new loan originations. CMBS spreads at the triple-A level tightened a respectable .05%.

Life insurers are a happy bunch these days, with investable funds and loan demand in sync. To be sure, the funds are concentrated on the short end. Most insurers have plenty of three- to five-year money, and there is a noticeable shortage of 10-year and longer funds, with a few exceptions. They indicated that they were getting spreads wider than conduit loans due to the perceived shortage.

For deals that institutions clearly view as triple-A - those with a true loan-to-value of 50% or less - spreads can be incredibly thin. Some insurers and pension funds are willing to offer loans with spreads in the 1.60% range, which is comparable to public CMBS securities that are in fact rated triple-A. They argue that their whole loans are at least as secure as the triple-A rated publicly traded versions.

For the first six months of this year, whole loans generated a respectable total return of 5.10%, according to the Giliberto-Levy Commercial Mortgage Performance Index. Although they outperformed investment grade CMBS, the whole loans lagged the high-yield CMBS, which posted a nifty 7.32% return. Meanwhile, aggregate credit losses continue to run at levels that haven't been seen for two decades. But for those with a nervous stomach, shopping centers did show a small rise in losses and, in fact, retail losses are now ahead of the three other major property types.

According to one Wall Street trader, the CMBS market as of late has been "boring and healthy." New securitizations are at a reduced level due to the lack of new originations, and nowhere is that more apparent than in a new securitization recently offered by GMAC Commercial Mortgage, Deutsche Bank and Goldman Sachs. Even though the deal combined collateral from three origination heavyweights, it still weighed in at just under $700 million. Another transaction led by Salomon Brothers further demonstrates the difficulty in originating fixed-rate conduit loans. Though four originators - including PaineWebber, ORIX and Artesia - were involved, the deal totaled only $785 million.

Recently, Donaldson, Lufkin & Jenrette priced a $438 million floating-rate securitization. The A-1 class rated triple-A was priced at LIBOR plus 0.26%, just slightly wide of DLJ's expectations. Traders noted that the deal garnered interest from European investors, including a $50 million buy from a London-based conduit known as K2.

In late July, CS First Boston priced a $1.1 billion fixed-rate securitization, which by all accounts traded well. Analysts noted that there was fierce competition for the tranches rated double-A and lower, with especially fierce combat in the below-investment-grade tranches rated double-B and double-B+, which priced at spreads of 5.20% and 4.75%, respectively. Interestingly, a number of buyers for these relatively small tranches were unable to buy any bonds due to the tight pricing. This surprising strength in the below-investment-grade tranches comes at the same time that Moody's is noting the continual decline in credit quality of U.S. corporations as downgrades swamped upgrades by a margin of two to one for the first six months of this year. But as is obvious from the above pricing, real estate buyers, at least on this transaction, seem not to care.

In what is believed to be a first, Deutsche Bank plans to securitize $200 million that had previously been "kicked out" as collateral from other securitizations by the buyers of the riskiest tranche. As these loans are viewed as tainted, spreads are expected to be extraordinarily wide. As we noted with CS First Boston, competition intensified for the higher-yielding and riskier tranches. Deutsche Bank may intend to target high-yield buyers for their "kicked out" collateral transaction. Deutsche Bank is said to be seeking other investment banks to join them in this endeavor. Company executives confirm that they are researching this concept.

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