Vital signs are dangerously low in the commercial mortgage-backed securities market. A threefold dilemma of slashed bond prices, weakening mortgage performance and non-existent loan origination has pummeled portfolio values and left borrowers without a critical source of commercial real estate financing. At the same time, fear of further losses has kept investors from administering the proper dose of transactions that would breathe life into the sector again.

“The machinery of CMBS is so broken that no one is interested in buying CMBS bonds,” says Clay Sublett, national production manager at KeyBank Real Estate Capital and former CMBS director for the Cleveland-based lender. “Even if new loans were originated at market rates today, there wouldn't be anyone to buy the resulting bonds.”

Borrowers will exercise options to extend virtually all of the $33.3 billion in floating-rate CMBS loans due to mature this year, putting off their need for new financing for three to five years, analysts say. More problematic are the $36.6 billion and $48.45 billion in fixed-rate maturities in 2009 and 2010, respectively. Add in non-CMBS loans, and the demand for mortgage financing may exceed $400 billion this year when credit has grown exceedingly scarce.

“We do not have a functioning mortgage market in commercial real estate today,” says Wayne Brandt, managing director of lending and equity investment at Newport Beach, Calif.-based Buchanan Street Partners. “Whether it's CMBS or commercial banks or life insurance companies, the traditional sources of mortgage financing are in a dormant state and dealing with their own balance- sheet issues.”

A functioning CMBS market, if it can be revived, may head off an approaching wave of defaults and foreclosures. What the industry needs is renewed trading in existing CMBS bonds, which would help to establish realistic pricing and get the sector moving again.

Path to recovery

But buying and selling won't return until investors feel confident that the bonds they purchase will at least retain their value without incurring further loses, according to Bill Collins of Cassidy & Pinkard Colliers.

“It's the falling knife,” says Collins, managing director of the capital markets group at the Washington, D.C.-based commercial real estate services firm. “People who bought CMBS in 2008 realize in January 2009 that they could have bought cheaper. They don't want to buy too early.”

What will it take to restore investor confidence in CMBS? Transparency and data, says Trevor Murray, director of CMBS research at UBS Securities. It will probably take at least 10 months for investors to get a feel for how well loans issued at the height of aggressive lending in 2006 and 2007 will perform in the face of recession-driven real estate fundamentals.

“The only way investors will get comfortable with increasing their allocation to CMBS is by monitoring performance,” Murray says. “There is going to be an incredible buying opportunity, but the market will be reluctant to act until it understands what commercial real estate is going to do over the next few months. Several investors were burned in 2008 by moving too early.”

Investors watching for the opportune time to jump back into CMBS will gain a clearer understanding by examining the sector's behavior through three different lenses, according to Jamie Woodwell, vice president of commercial/multifamily research at the Mortgage Bankers Association (MBA). Those areas are pricing, performance and issuance.

Fearful investors have touched off an unprecedented surge in CMBS spreads, essentially the basis points added to a benchmark rate to compensate bond holders for risk. In early November, the spread on AAA-rated CMBS was 549 basis points higher than a year earlier and 650 basis points over swaps, then shot up to an incredible 1,400 basis points in the week before Thanksgiving. Swaps are a premium investors pay when trading floating- for fixed-interest streams, and provide a base rate for some CMBS bonds.