The spreads between 10-year Treasuries and CMBS loans now jump more in a couple days than they did in whole years. Those 10-year, interest-only loans borrowers were getting? They vanished weeks ago. And conduit lenders are getting revamped underwriting standards handed down from on high every couple of days because the market is changing so fast. Borrowers, meanwhile, acutely aware of the tremors shaking the debt markets, are holding back and waiting to see where things settle. As a result, conduit lender activity dramatically diminished over the course of just a few weeks.

And all this is just on the origination side of the equation. The securitization market has also slowed. Investors in CMBS bonds have pulled back sharply. By some estimates there's a backlog of $50 billion in securitizations brought to the market that investors haven't touched.

This is what contagion looks like.

Contrary to assertions months ago that fallout from the subprime mortgage meltdown had been “contained,” new problems seep out of the woodwork seemingly on a daily basis.

As a result, the fixed-income markets are in complete disarray. Panicked bond investors are running for the hills, pulling money out of mutual funds that invest in asset-based securities and instead buying Treasuries by the truckload. As of late August, yields on the 10-year bill had dropped all the way down to 4.58 percent — down nearly 80 basis points from a June high of 5.32 percent.

“We're talking about illiquidity that far exceeds what's happening in CMBS,” says Jere Lucey, managing director of Jones Lang LaSalle's Capital Markets Group.

“The good news is that CMBS is now considered a core fixed-income investment,” adds Lisa Pendergast, managing director of real estate finance for RBS Greenwich Capital. “The bad news is now that we have graduated to that level, we have to take our lumps with the rest of the market when they occur.”

Fears of how deep the problems go have shaken Wall Street to the core. The three major stock indices — the Dow Jones Industrial Average, Standard & Poor's 500 Index and the NASDAQ — have fluctuated wildly in recent weeks. After the Dow peaked over 14,000 it fell into a technical correction (down 10 percent) before intervention from the Federal Reserve Bank helped push markets back up a bit. The Fed pumped tens of billions a day into the markets for nearly a week then cut the discount rate 50 basis points to 5.75 percent. That calmed markets for a bit. But no one knows what will happen when the next unexpected flare-up occurs.

Beyond the panic, though, what's the big picture?

Everything related to real estate has seemingly been tainted by the subprime crash. It's dragged commercial real estate, despite solid fundamentals in every sector, along for the ride. (For more evidence, look no further than REIT stock prices, which have taken a beating in recent months for no discernible reason.) Similarly, while residential mortgage-backed securities have become the source of major headaches, there have been very few problems to date in the CMBS sector.

So CMBS lenders are, unsurprisingly, discouraged about what's going on in the market. While they acknowledge that in recent years they may have gotten a bit too lax in underwriting and contributed to the overzealousness in the market, they have not yet been burned by defaults or delinquencies. Across the nation and across commercial property sectors, vacancy rates are down and rental rates are up, and CMBS defaults (loans that are delinquent for 60 days or more) are close to historic lows with a default rate of just 0.33 percent and an outstanding delinquent balance of just $1.6 billion, according to RBS Greenwich Capital.

Yet, the more investors read about how bad things are, the more frightened they become, and they end up buying fewer bonds — even if issuances start getting sold for less than they are worth. “If they keep retreating, we won't be able to sell CMBS at any price,” says Danielle Violi, senior vice president and head of KeyBank's structured finance group.

One industry player says previous commercial mortgage securitization deals attracted as many as 80 fixed-income investors. Today, only a few show up, and the investors who are still buying CMBS are demanding that a higher level of risk be priced into all tranches of CMBS, causing spreads to widen significantly across the credit spectrum (see chart below).

Ory Schwartz, a senior vice president in NorthMarq Capital's Los Angeles office, recalls that the lending market was so hot during the first quarter that he closed a 10-year interest-only, $12.5 million loan for a retail center in Southern California at 80 percent LTV at a 100 basis point spread over 10-year Treasuries (about 5.6 percent).

“If I were to go to market today on the same deal, the spread would be double and we'd be lucky to get two years IO and about 65 percent to 70 percent of the purchase price,” Schwartz says.

Bond investors are demanding higher yields for commercial mortgages because they want to avoid any repeats of the subprime fiasco. (In many cases, it turns out, the same investors buying the riskiest residential mortgage-backed securities were also buying the riskiest CMBS tranches.)

“Investors are looking more closely at the risk associated with CMBS, and the concern going forward is that there may be defaults if the market environment ever changes and becomes less favorable,” says Scott Tross, a litigator with Herrick, Feinstein LLP, a Newark, N.J.-based law firm that represents buyers and sellers of distressed CMBS paper.

Overly aggressive

If some do get burned, they can't say they weren't warned. Even before the subprime fallout, ratings agencies had sent up warning flares about CMBS lenders becoming too aggressive. In the spring, Moody's Investor Services said in a report that it was concerned that conduits had become too aggressive in their loan underwriting and pricing.

Fitch Ratings issued a similar warning in April, projecting a 15 percent increase in CMBS defaults (up from the 3.7 percent average of the past decade) because CMBS lenders originated too many loans based on a properties' projected — rather than existing — income streams.

“It got to the point where conduits could and would do any loan,” says Mitchell Zeemont, a managing principal with Newmark Realty Capital, a San Francisco-based mortgage banking firm. He admits that he always expected that something would cause an underwriting correction, but he certainly didn't envision a complete meltdown in the bond markets.

Whatever the cause, CMBS lenders are reacting to the new conditions. They are getting more conservative and making loans with a view toward selling them in current market conditions, says Tross

On Friday, Aug. 10, a $3.6 billion CMBS deal priced at a benchmark of swaps plus 76 basis points. The deal, WBCMT2007-C33 sponsored by Wachovia and Barclays, is one of about nine deals in the market — more than average. Normally, only four to six deals are in the market at any one time.

Plus, Lucey points out that collateralized debt obligation (CDO) issuers were big buyers of CMBS and they have been forced out of the market because a high percentage of CDOs were exposed to subprime bonds they can't sell off.

“A lot of bond investors are hearing from senior management at levels they never heard from before, with managers asking what kinds of structured finance products are in the portfolio,” Pendergast says. “When you're under that kind of scrutiny there's very little likelihood that you're going to step in front of a runaway train.” As a result, some B notes aren't getting priced in the market at all.

Trouble at the warehouse

More disciplined underwriting solves the issue of future loans. The, problem, though, is that the industry was issuing loans under the old standards until very recently. And that last batch of loans made under old conditions has not yet been sold.

Loans with really aggressive terms like 10-year interest-only, 80 percent loan-to-value and debt service coverage of less than 1.0 x remain sitting in the warehouse waiting to be securitized. They will have to be sold at steep discounts.

Experts estimate that anywhere from $40 billion to $50 billion worth of stale CMBS paper is “warehoused” on balance sheets and credit facilities.

The fact is many of the CMBS deals currently in the market are collateralized by loans that were committed in March or April — well before the subprime contagion spread to the CMBS market and the rating agencies voiced concerns over underwriting.

The warehoused paper is problematic enough to make some experts think it will drive some smaller CMBS lenders out of the market. Such players don't have the capacity to hold onto the paper without gumming up their credit lines.

And, if most lenders began to improve their underwriting standards in May or June, those loans won't be ready for securitization until early September. That's when the market will get an idea of how far lending standards have improved.

Increasing delinquencies

In July 2007, the ratings agencies took action on 329 classes in 101 fixed- and floating-rate CMBS. As usual, upgrades outpaced downgrades, with 310 bonds upgraded and only 19 downgraded. The overall upgrade-to-downgrade ratio, while still high, slipped to 16:1 in July, down from 18:1 in June.

But, delinquencies among rated U.S. CMBS increased by 12.7 percent during the second quarter, the first rise since the amount delinquent peaked in December 2003, according to Standard & Poor's (S&P). At the end of the recent quarter, $1.65 billion in CMBS loans were delinquent, up from $1.46 billion in the previous quarter.

An interesting trend within that is that loans issued in 2005 and 2006 are going faster at a higher rate than older loans. Loans in those two years experienced the largest quarterly increase in delinquencies over the past two quarters (98.5 percent and 172.5 percent, respectively) of the vintage years in the period between 1995 and 2006. Comparatively, the other vintage years have seen delinquency increases ranging from 1.28 percent to 9.24 percent.

While making recent calculations, S&P found that delinquent amounts went up another 4.5 percent from June to July, increasing to $1.72 billion. The 2006 vintage moved up at an even greater rate — up 42 percent between June and July.

Still, because of the huge volume of CMBS originations during the quarter, the overall delinquency rate increased by only one basis point inching up to 0.28 percent from 0.27 percent.

There was more variety at the property level. Health care, office, and industrial property types experienced declines in their delinquency rates, while lodging, retail, and multi-family sectors saw increases. At the end of the quarter multi-family had the highest delinquency rate at 0.81 percent, followed by lodging at 0.46 percent, health care at 0.35 percent, industrial at 0.29 percent, retail at 0.15 percent, and office at 0.11 percent.

Still quoting loans

Even as bond investors demand higher yields and delinquencies become a larger concern, many CMBS lenders are doing their best to stay active. “This market is limping along, but it's still moving,” Pendergast says, adding that most CMBS lenders still have liquidity on their balance sheet for mortgage loans.

Domestic CMBS volume is up almost 79 percent for the first seven months of 2007, according to RBS Greenwich Capital. Monthly volume in 2007 has averaged $24.4 billion compared to a 2006 monthly average of $17 billion.

August volume could total $31 billion, with $19.1 billion of that in conduit transactions, and another $26.7 billion is projected for September, with $14.6 billion in conduit/fusion deals. The bank predicts that CMBS issuance volume will drop dramatically in October, with current projections of just $10 to $15 billion.

However, pricing is tricky. The market is moving so quickly that spreads are moving as much as 10 basis points per day, according to Pendergast, staggering volatility considering that spreads only deviated by 7 basis points during all of 2006 on AAA.

KeyBank also continues to quote loans, although Violi says the bank is expecting a significant decrease in origination volume. However, KeyBank has definitely made some changes to its underwriting. KeyBank is still offering IO loans, but at conservative LTVs.

For all their efforts to quote loans, most CMBS lenders aren't able to stand by them, says NorthMarq's Schwartz. “Borrowers have to go into a deal understanding that if someone quotes them a deal and they rate lock it, and the market crashes even further, the lenders are hard pressed to keep those terms intact,” he says.

In fact, more and more CMBS lenders are relying on the material adverse change provisions within the loans that allow them to widen the spread and change the terms of the deal up to the point when the money is wired. One of Zeemont's recent financings is a case in point — a client locked in a conduit loan in mid-July at 6.15 percent, 10-year IO, sub 70 percent LTV and the conduit repriced the loan, bumping the spread 15 basis points.

CMBS players are keeping their fingers crossed that the current situation will be resolved once bond investors recognize that CMBS bonds are still a good investment. Pendergast says that fixed-rate CMBS AAA bonds represent excellent risk-adjusted rewards for bond investors.

“At this point, bond investors are window shoppers,” Pendergast says. “They're looking for bargains and are not ready to pull the trigger. But, the concern will eventually become ‘Will I get my head handed to me for not stepping up and getting involved in the sector?’”

Based on RBS Greenwich Capital's relative-value spread model, 10-year SS AAA CMBS now trade cheap to all competing asset classes with Z-scores of between +1.0 and +5.3. Almost all the Z-scores are “off the charts,” a dynamic that has never occurred during the five years since the firm began doing such an analysis.

And, it's worth noting that CMBS spreads have widened more than most competing fixed-income investments because investors have been selling off CMBS to pay margin calls on other investments gone bad, like RMBS and CDOs.

“There will be a lot of money made by savvy investors who realize this CMBS paper is still a good investment,” says Gerard Sansosti, senior managing director of Holliday Fenoglio Fowler L.P.

“They just need to start buying again,” Sansoti says.

CMBS SPREAD INCREASES
  Spread to Swaps/LIBOR Spreads to Treasuries
Fixed-Rate CMBS 8/10/07 2006 Avg. CHANGE 8/10/07 2006 Avg. CHANGE
AAA-3Y SS 40 8 32 101 51 50
AAA-5Y SS 62 17 45 128 65 63
AAA-7Y SS 80 25 55 150 76 74
AAA-10Y SS 70 24 46 141 77 64
AAA-10Y Mezz. 78 27 51 149 81 68
AAA-10Y Jr. 95 30 65 166 84 82
AA 140 35 105 211 89 122
A 190 45 145 261 99 162
BBB 325 81 244 396 134 262
BBB- 425 111 314 496 165 331

Floating-Rate CMBS
AAA Jr. 35 11 24      
AAA Jr. 50 11 39      
AA 70 24 56      
A 115 37 78      
BBB 200 83 117      
Source: RBS Greenwich Capital