The ups and downs of the CMBS market

The commercial mortgage-backed securities (CMBS) market was back on center stage in late May as four major conduit transactions priced in four days. There were some nervous moments, especially surrounding the pricing of a $980 million fusion transaction from GMAC Commercial Mortgage. (Fusion transactions are securitizations which involve not only standard size conduit loans but large loan transactions as well.) Triple-A spreads, which dipped briefly below 1% in mid-May and were at 1.18% for the two previous deals, suddenly skyrocketed to 1.3% over for the GMAC transaction. But a long-term trend it wasn't. In the words of a mutual fund manager, it was merely a "headfake," and spreads tightened almost as abruptly as they had risen.

The most impressive transaction of the four, and also the largest, was a $1.6 billion securitization offered by Lehman Brothers. The mortgage pool consisted of almost 200 loans, some 58% of which were garden-variety conduit offerings. But what appeared to pique buyer interest was that almost 40% of the pool were large loans from companies considered to have an investment-grade rating. Given the attractive nature of the collateral, spreads tightened considerably with the A-2 class, rated triple-A, pricing at a spread of 1.2%, while the D class, rated triple-B, priced at a sizzling 1.8% spread.

The yo-yo effect Watching triple-A spreads in the CMBS market is closely akin to watching a yo-yo - they go up and down with dizzying speed. In fact, according to numerous market observers, triple-A spreads really trade off of so-called "technical factors" and have virtually nothing to do with the quality of the underlying real estate. One of the most closely watched technical factors is the market for interest rate swaps. Many buyers of fixed-rate 10-year triple-A CMBS swap it for a LIBOR-based floating rate. Thus, when swap spreads increase, fixed-rate triple-A spreads increase as well, even though that is no reflection on the real estate market.

CMBS buyers have noticed that rating agencies are requiring lower subordination levels than ever before. In the words of one observer, "the rating agencies have a blue light special on credit support levels now." For example, in the four transactions recently priced, the rating agencies required subordination levels that ranged from a maximum of 28% on the GMAC transaction to a very thin 23% on the Lehman Brothers transaction. Credit support levels are the percentage of the securitization that are not rated triple-A. All things being equal, a higher credit support level gives greater comfort to securities buyers. Credit support levels are dropping significantly at a time when many question whether it is too late in the real estate cycle to make such a positive move.

Demand's demise Although the securitization market is doing quite well, loan origination levels are struggling, and that is affecting both institutional lenders as well as Wall Street. Many conduit originators are reporting that their new originations are down some 30% to 50% from planned levels. On the insurance company side, loan demand appears to be only fair. The recent rise in Treasuries has sent numerous borrowers to the sideline. There are clearly numerous transactions being discussed - also known as "noise" - but a large number of borrowers decide not to proceed once they discover the interest rate and leverage level that they can obtain. Confirming the lack of new originations, a number of life insurers reported that loan payoffs in 1999 are one-third to less than they were during a similar time period last year.

Looking ahead, industry analysts sense that the lack of new transactions will keep commercial mortgage spreadsheaded south. CMBS markets could have a quiet July and August for the first time in years. Another frequently mentioned factor influencing spreads is the inclusion of CMBS in the Lehman Brothers aggregate bond index beginning July 1. Bond indexers will be required to buy CMBS in order to match the index or possibly suffer the consequence of being "out of index."

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