For the past two years, the market for commercial mortgage-backed securities, while still sizable, has been tougher and somewhat messy. No longer the hottest thing on the Street and faced with more competition for fewer maturing loans and a more costly interest rate environment, the CMBS market peaked year before last and has been losing steam ever since. The expectation for the year 2000 is more of the same.

Pummeled by outside economic disasters such as the global credit crunch of 1998, over-primed by a hoard of conduits, pinpricked by rising interest rates and abandoned by former high-flyers like Nomura, the CMBS market has begun to resemble a post-fight boxing champ, bruised and battered but still standing.

Last year's $66.2 billion in CMBS issuances was still the industry's second busiest year, after peaking in 1998 at $78.3 billion. The most optimistic projection for 2000 is that issuances will run about the same as the prior year. On the other hand, pessimists see issuances dropping to approximately $55 billion.

The two principal economic factors affecting CMBS this year are interest rates and lack of refinancings.

"Our expectation for 2000 is a decline of about 15% in total CMBS issuance, which we attribute to a couple of things," explains Brian Lancaster, a managing director and CMBS strategist at Bear, Stearns & Co. Inc., New York.

The first factor affecting CMBS, Lancaster says, is that interest rates are higher by about 200 basis points than they were a year ago, which means there will be fewer feasible real estate projects. Higher interest rates push up cap rates.

The second factor is partly historic. At the beginning of the 1990s, there was a trough in commercial mortgage originations due to the real estate recession at the time (down about 60% to 80% from the end of the 1980s). Therefore, to the extent that commercial mortgages tend to have 10-year lives, there are fewer mortgages to refinance at the present time, a condition that will probably last through 2002. "We are at a refinancing low in the cycle," concurs Gale Scott, a managing director at Standard & Poor's in New York.

While those issues are serious enough to prick the CMBS bubble, there are other problems as well, says Scott. To be factored in is the current lack of real estate investment trust acquisition activity and extremely strong competition from insurance companies and commercial banks - the banks have racked up a 23% increase in commercial loans.

The new asset mix Tad Philipp, managing director of New York-based Moody's Investors Service, believes 2000 will be a year of change in the CMBS market. Going into a decline will be issuances of U.S. fixed-rate conduits, as issuers report a slowdown in production. Philipp reiterates the litany of woes - lower levels of maturing loans, lower levels of acquisitions and, of course, the interest rate hikes - that will prompt some borrowers to sit on the sidelines. And, there's less incentive to buy when cap rates are rising. The hikes will reduce "the arbitrage relative to cap rates that helps drive acquisitions financing," he says.

However, even with the turmoil, Philipp predicts much of the slack will be taken up by increases in other CMBS product lines, large loan production, floating rate loans, small loans and international transactions:

* Large loans - Increases involve single properties and cross pools. The boost reflects continuing financial flexibility constraints on REITs, as well as the limited number of private market lenders willing to make loan commitments in excess of $100 million.

* Floating rate loans - As in the residential market, borrowers are now opting for floating rate loans while waiting for rates on fixed-rate loansto come down.* Small loans - More loans under $2 million as several issuers ar e gearing up in this area.

* International loans - Several international markets have moved beyond the portfolio liquidation stage into the conduit stage.

Of those four product lines, international and floating rate loans are expected to shoulder the burden of keeping the CMBS volume consistent with the prior year.

Floating rate loan buoyancy This year, GE Capital introduced a new loan product called a float-to-fix. The product, underwritten to CMBS standards, carries an initial floating rate and an option that the borrower may switch to a fixed rate at some point in the future.

"We are pretty excited about this," says Kathy Cassidy, a senior vice president and managing director at GE Capital Real Estate, Stamford, Conn. "It is always necessary to focus on the customers' needs. Sometimes they want a longer-term, fixed-rate product, and sometimes they want a shorter-term product."

Cassidy adds, "We try to win as much product as we can. Obviously fixed-rate has come down a little from last year, so we introduced this new product [float-to-fix loan] because we wanted to be ready in regard to where the market is headed."

GE Capital Real Estate tries to be flexible, not only on origination but in securitization as well. In fourth quarter 1999, the company closed two fixed-rate deals plus one floating-rate.

With the recent acquisitions of the Eberhardt Co., Cauble and Co. of Carolina, North Coast Mortgage, Shoptaw-James, and Carey Brumbaugh Starman & Phillips, Houston-based L.J. Melody & Co. can safely call itself one of the largest mortgage banking companies in the country. Even in this year's choppy market, the company continues to do conduit origination. "There are still refinance opportunities out there and some acquisition opportunities," notes Brian Stoffers, an executive vice president with L.J. Melody. "Also, there are some REITs trying to shed some of their non-core assets and we are trying to provide some answers for them."

Still, with interest rates up, Stoffers says his company is doing "a lot of floating rate product" plus bridge-type financing and mezzanine loans.

For the year 2000, Moody's Philipp simply observes, the volume of "fixed-rate (loans) will be down, floating-rate will be up." For the past few years, he says, floating rate loans were primarily originated for properties in transition, where the borrower wanted prepayment flexibility in order to be able to seek a long-term, fixed-rate loan with maximum proceeds upon stabilization. Now, however, borrowers are simply waiting for the rates to go down.

In fact, adds Standard & Poor's Scott, "We will see more floating rate CMBS this year than ever before in the CMBS market."

International takes off The big surprise in 1999 CMBS volume was how important the international market had become. Of the $66.2 billion in CMBS volume last year, about $9 billion of that came from international. This year, the market reliance on international could be even more pronounced. Even if CMBS remains stable, international is expected to jump to $15 billion, not bad for a sector that wasn't even a blip on the screen three years ago.

"Last year there was a big surge in international," comments Bear Stearn's Lancaster. "This year you will see another (big surge)."

Bear Stearns has been working overseas in the residential market and is now looking to do the same in the commercial markets. Last fall, the company handled the first securitization of residential mortgages in Japan, a deal that was worth a couple of billion dollars. It also was involved in residential securities in Belgium, the Netherlands, France and England. "What we like to do is leverage off the residential and go into commercial lending as well," says Lancaster.

Not everyone is so sanguine about being overseas. Credit Suisse First Boston has done some securitized deals in Mexico and Canada and is looking around Asia. But, as Mark Finerman, a managing director at CSFB notes, there is still plenty of work in the United States. "Just look out the window. As far as the eye can see there is plenty of product."

GE Capital is basically in the same frame of mind as CSFB. "We have about 200 people in Europe so we have a lot of eyes and ears out there," says Cassidy. "If we see something we are poised to react very quickly, but we really don't see Europe to be as big an opportunity as the United States. We have focused all of our efforts to really grow with the market here."

While that may be so, Clayton Hunt, director of International CMBS with New York-based Standard & Poor's, maintains that over the last 12 months there has been dynamic growth in the international market.

"There has been a lot of work done, particularly since 1996, to educate not only international investors, but issuers and bankers alike as to what the CMBS product is all about," says Hunt. "Last year, the international CMBS market began to take off and this year it is going to be explosive in terms of total size, particularly out of Europe and in places like Australia, Canada and Hong Kong."

As noted, CMBS volume could easily slip again this year, which means that if international even moves up to the most pessimistic estimate, $12 billion, that will mean a much larger percentage of total volume will be coming from international.

On an anecdotal note, one observer points out that Lehman Brothers has traditionally been the No. 1 CMBS player in the United States, but was upset about losing the lead to Morgan Stanley Dean Witter, which executed a very large deal in London last year. Now, the observer says, Lehman is beefing up its staff overseas.

Last man standing L.J. Melody & Co. originated over $4 billion in CMBS last year. Since, the company doesn't take any principal risk, it originates on behalf of other lenders such as GE Capital and J.P. Morgan. "We do business with almost all the largest conduits," says Stoffers. "Most of our business is pretty well concentrated in the top eight or so companies."

Nevertheless, Stoffers notes, the recent years haven't been kind to conduits. "They have a competitive product and were hurt by rising interest rates, which fluctuated pretty wildly last year," he says. "That caused business to ebb and flow more than they would have liked. What we are seeing now is an overall oversupply of lenders trying to hang on. Some of the more well-funded conduits are going to survive and some of those that are not capitalized quite as well are going to have a tough time."

But these same predictions have been made since 1998 when the international credit crunch smacked the industry. Back then, some companies exited the business, but almost everyone else hung in there.

Stoffers recognizes that fact. Still, he says, the combination of narrow profit margins and lower volumes will shake out the market this year.

Those sentiments are shared by Hunt of Standard & Poor's. "The margins the conduits enjoyed early in this industry's development have dwindled down to a very small number over the past four years," says Hunt.

"They have gotten to the point where, coupled with other factors such as competition from banks and life companies, some issuers need to think long and hard about whether to continue in the industry."

Two companies expected to hang in there are Bear Stearns and Credit Suisse First Boston (CSFB), but for different reasons. With about $1.07 billion in CMBS last year, Bear Stearns is not a major conduit. Even if it meets its target this year of $1 billion in fixed- and $1 billion in floating-rate financings, it still will be a mid-tier player. But that's not a bad place to be.

"Because Bear Stearns is not a huge volume lender," says Lancaster, "we are not as affected by the overall market as some others are."

CSFB, on the other hand, is a bit of surprise. After the credit crunch of 1998, it effectively wasn't writing much in the way of new loans. However, by the fourth quarter 1999, it was probably doing more business than any other firm.

"The year 2000 is going to be choppy, and we will see who really wants to be in this business," says Finerman. "Will people pull out? Yes. By the end of 2000, the people left are the ones that you will know are serious about this business."