Stacey Berger: Weak underwriting standards cloud booming CMBS market

As executive vice president of Kansas City-based Midland Loan Services, Stacey Berger oversees a $228.4 billion commercial loan-servicing portfolio. He's also spending more time these days analyzing a growing number of potential market risks. From lax underwriting practices to an implosion in subprime credit, Berger worries that this buoyant market could be approaching some speed bumps.

He's certainly in a position to know. Midland provides third-party loan and asset management services to commercial mortgage-backed securities (CMBS) and real estate collateralized debt obligations (CDO) issuers and investors. The company has grown its business during prosperous times. The Mortgage Bankers Association, a Washington, D.C.-based trade group, ranked Midland as the third-largest loan servicing firm in 2006 with annual servicing volume of $213.4 billion. Berger spoke to NREI about the strong market for securitized commercial real estate debt, and why he believes that growing distress among residential subprime borrowers could impact CMBS and CDO investors.

NREI: Give us your thoughts on deteriorating underwriting and origination standards for commercial mortgage loans. Should investors be concerned?

Berger: People are concerned. Underwriting continues to deteriorate, but commercial mortgage credit continues to improve. It's also at historically good levels. The rating agencies have been jawboning this issue for a long time, and they're finally getting more active by raising subordination levels to account for what's happening in the market.

NREI: The growth of the CDO market has led many subordinate and mezzanine investors to shift risk into CDOs rather than adopt the classic “buy and hold” strategy. What's the net effect on market discipline?

Berger: CMBS subordinate investors have certainly benefited from the ability to lay off risk in CDOs. That said, they are in the business of acquiring subordinate CMBS and also being CDO issuers. While credit performance is important, there is very much a short-term mentality in the marketplace.

NREI: Do investors fully grasp the risks that CDOs pose, and are they being compensated for taking these risks?

Berger: It's hard to say if they really understand the collateral underlying these CDOs. But it's somewhat of an arbitrage market at this point. There are a lot of European money funds that are buying investment grade CDOs strictly on the ratings. These are not imprudent folks. The fundamental issue is that many investors aren't being paid to take these risks.

NREI: The news about the subprime market isn't getting any better. Should CMBS and CDO investors be concerned about this residential credit crunch?

Berger: The two markets are certainly close enough that a major blowup in subprime could ripple through the CMBS and CDO market. But we absolutely expect 2007 to be another record year for CMBS and CDO issuance.

NREI: Have spreads reflected this imminent risk as investors demand higher returns?

Berger: The distress in the subprime market has had an effect on CMBS credit spreads and CDO issuance. The markets have recently gotten much choppier and spreads have widened. It hasn't been a disruption to the market, but it's clearly more volatile than it has been recently.