We've all experienced that uncomfortable feeling of pushing away from the Thanksgiving table after eating one too many slices of Aunt Betty's blueberry pie. That's how the commercial mortgage-backed securities (CMBS) market feels these days — too much food, too few mouths, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

The market for CMBS literally exploded in 2005, up more than 60% from the previous record set a year earlier. As 2005 came to a close, analysts expected spreads to drift somewhat wider to entice big money managers and insurers to buy yet another $20 plus billion in offerings.

In early December, two new offerings — the first a $3.1 billion securitization led by Merrill Lynch and the second, a $2.4 billion offering from GE — were priced at spreads that rivaled the widest levels seen all year. CMBS spreads have a habit of tightening early in the New Year, and the smart money seems to be betting on that occurring again in early 2006. But as the seconds ticked away on 2005, the market appeared sloppy and clearly lacking in focus, so further short-term widening, especially in the lower investment-grade tranches, appeared to be a sure bet.

Wider spreads have caused a number of buying opportunities for investors willing to take a position. A number of industry insiders are suggesting that the junior triple-A tranche, known as the AJ tranche, now offers significant value. Based on offerings in early December, AJ bonds were expected to trade at levels touching 100 basis points over the Treasury curve.

At those levels, and whole loans priced at 100 to 115 basis points over Treasuries, MFS Investment Management's Vice President Josh Marston sees the AJ sector as offering compelling spreads. But Managing Director Rob Bloemker of Putnam Investments isn't as sanguine, noting that “investors should think twice before calling it a screaming buy.”

New CMBS player emerges

Hedge funds are everywhere these days, and they're no longer sticking to their previous knitting, which revolved around the buying and selling of stocks, bonds and derivatives. More than a few have been active buyers in the CMBS arena, especially in the lower-rated tranches. But lately, a significant number are offering to originate whole loans, mezzanine debt, and preferred equity transactions in numerous markets across the country.

Additionally, more than a handful of insurers and other institutional lenders are trying to partner up with hedge funds so that the funds can take the more leveraged portion of loans that insurers are able to originate. Generally, first-mortgage loans don't hold much lure to this group as yields don't come anywhere close to their hurdle rates, unless the loan requires quite unusual terms or are on properties that don't lend themselves to a more conventional lending process.

But more than a few funds have made first mortgages and sold the secure senior piece to other investors while keeping the more highly leveraged and higher returns of the junior tranche. A few of the active players in this sector include Perry Capital, Farallon Capital, Och-Ziff, Guggenheim Real Estate and BlackAcre, now known as Cerebrus Capital.

Credit-quality risks

News articles about the softening housing markets appear almost daily, causing a bit of sympathy pains in commercial mortgage land. In the home equity loan arena, triple-B spreads, which were trading as tight as 120 basis points over LIBOR 90 days ago, have widened to 225 basis points. Investors are worried that flat to weak housing prices will cause significant defaults in this subprime market.

While triple-B CMBS spreads have performed dramatically better, there's always a chance that investors concerned about commercial mortgage credit quality could short credit default derivatives and cause spreads to widen dramatically. As Managing Director Lisa Pendergast with RBS Greenwich Capital puts it, “There are growing concerns about credit quality in lower rated investment-grade bonds.”

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.

BARRON'S/JOHN B. LEVY & CO. NATIONAL MORTGAGE SURVEY

Selected CMBS Spreads*

	To 10-year
	U.S. Treasuries
Rating	12/5/05	10/31/05
AAA	87-88	75-76
AA	103-104	92-93
A	114-115	102-103
BBB	172-177	159-164
BB	300-325	300-310

Whole Loans*(Interest Rates)

	Prime	Prime	Prime
	Mtge. Range	Mtge.	Mtge. Range
Term of loan	12/5/05	Rate	10/31/05
5 years	5.51-5.61%	5.56%	5.55-5.60%
7 years	5.54-5.64%	5.59%	5.60-5.70%
10 years	5.64-5.74%	5.69%	5.67-5.77%
For loans of $5 million and up, on amortization schedules of 25-30 years that can be funded in 60-120 days with 0-1 point.

*In basis points, or hundredths of a percentage point.