Once you have tasted it, you don't like to give it up." The observation by Shekar Narasimhan, chief executive of WMF Group, could have been about any tempting delight - expensive wine or exotic food. But it wasn't. Narasimhan was referring to something more prosaic - commercial mortgage-backed securities.

The Vienna, Va.-based WMF Group was one of the first conduit lenders burned by capital market turmoil. Near the close of summer 1998, the company announced it would take a $30 million pre-tax loss connected to loans originated by its conduit unit.

Did the painful and sudden loss cause Narasimhan to give up the conduit business? Not at all. The problem going forward for WMF Group was how to stay in the business because it didn't want to give up its $12.1 billion in loan servicing, $150 million of assets under management and roughly 3,200 customers. "We had to change our strategy," says Narasimhan.

"Right after the debacle, we said right away we can do anything [in the conduit business] except take the risk - principal risk - during the period of aggregation of the loans," explains Narasimhan. "We had to go find a partner with a balance sheet that could support that risk and the capacity to manage the balance sheet through an interest-rate cycle or two." WMF Group found that partner, Greenwich Capital, and the two formed an alliance.

Decade of decision The 1990s had been an expansive decade for CMBS. From just $4.8 million annual production of CMBS in 1990, volume steadily rose through last year. CMBS volume climbed to a record $44 billion in 1997, but that mark was nearly eclipsed at mid-year 1998 as the volume reached a staggering $78 billion for the full year.

All was not, however, copacetic. In fact, 1998 made for a very tumultuous year. The virtual collapse of Russia's capital markets touched off a global flight from financial risk of all kinds. The mad rush to dump almost any kind of risk investment brought down even the high-flying CMBS market. Big players such as Nomura dropped out of the business, some investment banks such as Credit Suisse First Boston have remained on the sidelines, mortgage REITs collapsed and the biggest non-investment grade buyer of CMBS, Criimi Mae Inc., filed Chapter 11.

Where some stumble, others find opportunity. As investment banks, which were pushing the conduit business heavily over the past three years, closed or slowed their lending at the end of 1998, others stepped up to the plate including commercial banks, insurance companies, credit companies and even pension funds.

LaSalle Partners Investment Banking Group works with clients arranging debt either on a portfolio or single-asset basis. The company currently is focusing on single-asset projects whether it is an existing property or new development. It works with a variety of capital sources.

"In the first half of 1998, the most aggressive sources out there were the conduits," says Michael Seifer, a vice president at LaSalle and head of its San Francisco-based Debt Capital Markets Group for the Western half of the United States. "Conduits were providing the best pricing, especially for the type of deals we were bringing to market." How-ever, at the end of 1998, Seifer says, the conduits stayed on the sidelines and although several life companies stepped up and filled the void, "the transaction pace slowed and almost came to a halt."

For LaSalle, deals that didn't get done last year are now in this year's pipeline.

"There is a lot more balance in the market today," Seifer maintains. "Life companies have developed conduit operations themselves. Several companies like GMAC and GE Capital have plenty of capability that will get them market share. And there are folks like TIAA-CREF that are out there placing money as well."

A LaSalle Partners Investment Banking Update reports, "In 1999, the CMBS market will be characterized by transition. Already a number of conduit operators have drastically reduced origination volume or exited the business. Large issuance is also expected from a number of conduits that are coming under mounting pressure to reduce inventory and clean up their balance sheets."

Commercial banking stronghold The commercial-banking community remains the largest lender in the industry. If there is a trillion-dollar market of commercial mortgage lending, banks have probably $400 billion to $450 billion of it, life insurers $150 billion to $200 billion, pensions a small $10 billion to $20 billion, and the rest to conduits, notes Paul Turovsky, a managing director at Bankers Trust (which is in the process of merging with Deutsche Bank). However, the lines get fuzzy because a number of commercial banks originate loans for their own conduits.

As Turovsky speculates, commercial bank lending for early 1999 will certainly take a dip, but in terms of market share commercial banks will still be the predominant lenders. He adds, "Conduits will definitely come back as people are starting to feel their legs again."

On the buy side, Turovsky says the investment-grade side of the marketplace has been flowing, "and it has moved at a more attractive price level than it did in the latter part of 1998. At the same time, the investment-grade side hasn't approached early-1998 price levels. On the non-investment and unrated side there is a lot of talk of aggressive buyers getting in there and seeking opportunities, but that is not really the case yet. People have sold investment-grade property in the latter part of 1998 and early 1999, but I'm not sure that non-investment grade inventory has moved."

Yaniv Tepper holds the title of real estate portfolio manager for Hartford, Conn.-based Altus Investment Management, a CMBS investor. Over the past three years, Altus' position in CMBS vaulted from $100 million to well over $1 billion. Most of its holdings are in higher quality AAA issues, although it does drop down to BBB and BB issues as well. Tepper likes the market.

"We still see a healthy amount of supply this year. To date, we are slightly ahead of last year's supply." Still there are some problems, especially in the non-investment grade issues. "Obviously the B-piece market is the most difficult to place, but it's also where the banks make the vast majority of profits on these deals. Until that market firms up, it will be a little touch and go," Tepper says.

As an investor, Altus was not put off by the turmoil in the markets. "We are longer term investors and we don't have the kind of inventory exposure that originators do. They are underwriting loans, putting it on their balance sheet and then trying to play the spread game between short borrowing in the bond market and lending long in the real estate market. Sometimes they get stuck with inventory when the market backs up. Origination is a different perspective. They are trying to originate loans and sell them into the public markets at tighter spreads, so when the spread reverses that can hurt them quite a bit."

The long-term future of the CMBS market is going to depend on the quality of the investments, adds Larry Melody, president of Dallas-based LJ Melody, a wholly owned subsidiary of CB Richard Ellis. "There has been a lot of B- and C-quality property in CMBS which was unusual in the marketplace. If there are delinquencies on some of the CMBS issues it is going to hurt business."

Melody adds, "Right now spreads are tightening across the board on CMBS paper and there are investors for almost all tranches with the exception of unrated pieces. It's hard to find buyers for unrated pieces, which means people are afraid of long-term real estate risk."

LJ Melody built a servicing portfolio of $11 billion. Last year, the company did about $7 billion in originations and $2 billion in CMBS. "We originated CMBS product for issuers for whom we are a known correspondent and they securitized," explains Melody. "We acted as a broker or mortgage banker for them. We originated business and they securitized which means we don't take securitization risk, we don't take accumulation risk."

Like the WMF Group, Dallas-based AMRESCO Inc. got roughed up by the capital markets turmoil and had to make adjustments. Last year, the company reported a net loss of $69.2 million, mostly due to unprecedented capital market conditions causing spreads on mortgage-backed securities and related instruments to widen significantly.During the fourth quarter, the company made a number of corporate adjustments, closing AMRESCO Residential Credit Corp., eliminating jobs, shutting down its bulk/correspondent home equity lending subsidiary and selling off loans.

Still, it had a taste of CMBS and wasn't going to give it up. So, as with WMF Group, AMRESCO moved to a strategy of removing principal risk and capital-markets exposure by no longer doing conduit lending as a principal. In addition, the company formed two alliances. In February, AMRESCO announced a joint venture with LaSalle National Bank in which commercial mortgage loans originated by AMRESCO will be funded by LaSalle and securitized by LaSalle's securities affiliate, ABN-AMRO Inc. The company also announced an affiliation with Morgan Stanley Dean Witter whereby AMRESCO will originate fixed-rate commercial mortgages to be purchased by Morgan Stanley and included in its CMBS securitizations.

"It's fair to say we ceased our conduit operations in 1998 and we have reinstituted the conduit as of the second week in February," says Ed Hurley, president of AMRESCO Capital. This year the company expects to do about $1 billion in originations.

AMRESCO is optimistic but it also knows CMBS transactions are not that popular after so many deals floundered when the conduits pulled out of the market in late-'98. "From the borrower's standpoint, they aren't sure they want to do CMBS loans. So it will take some time to win those borrowers over," says Steve Beyers, vice president of CMBS lending for AMRESCO Capital.

In the long run that attitude will change, Beyers adds. "We have seen moderate demand from borrowers based on hesitation. The agencies and the life companies are very strong right now but in the latter half of the year as the life companies fill their allocations and borrowers get comfortable with CMBS lenders again, the demand on CMBS lender volume will pick up."

Quarter by quarter Actually, the first quarter looked good for CMBS, when about $20 billion in new CMBS came to market. In addition, there were a couple of major securitizations including a $1.3 billion offering by Deutsche Bank. The Deutsche Bank transaction was typical of the size of securitizations the market will see this year. Instead of warehousing loans for huge "megadeals," originators are pushing new mortgages to market at a faster pace.

By the second quarter there may be a slight hiatus in originations as there is not a lot in the pipeline.

"The interesting thing to focus on is what kind of run rate the industry is in right now in terms of commercial mortgage conduits," says Clay Lebhar, newly appointed head of the Real Estate Debt Capital Group, a division of the Real Estate Department of Prudential Securities' Investment Bank. "Depending on who you talk to, the volume range is generally 30% to 60% less than it was a year ago. Run rates are infinitely less than in 1998. The major players are hoping that it changes for the better."

The big question is how good will origination volumes be, adds John Westerfield, managing director and group head of CMBS at Morgan Stanley Dean Witter. "A lot of borrowers are sitting on the fence right now because interest rates have gone up and spreads are wide compared to where they were."

Westerfield notes that the large volume of securitizations that came in the first quarter were mostly transactions left over from 1998. Still, he says, "They went really smoothly so the market is very receptive and spreads have continued to tighten. The tone of the market is very good and on the origination side everybody is very competitive."

Morgan Stanley has consistently been a top player in the CMBS market, ranking No. 2 behind Lehman Brothers as the lead underwriter with about $15 billion worth of CMBS last year. In addition, the company originated about $5 billion of fixed- and floating-rate mortgage loans in 1998. Westerfield expects Morgan Stanley Dean Witter to do about the same amount of originations this year as last.

Conduits that got into high-risk lending practices have slowed their business, observes Westerfield, but the major Wall Street CMBS players such as Morga n Stanley, Lehman Brothers and Merrill Lynch will stay busy in 1999. "They are extremely well capitalized, have enormous balance-sheet liquidity, understand the pricing and the rating-agency sides of the business and have powerful distribution capabilities. Yes, they are absolutely going to stay in this business."

Not mentioned by Westerfield, but an investment bank that entered the CMBS market gingerly and has slowly picked up speed is Bear Stearns. Last year, the company did about $1.5 billion in CMBS originations and this year it expects to do $1.5 billion to $2 billion. "The overall CMBS market is not expected to grow from 1998 to 1999 and perhaps will even shrink slightly so those companies that maintain market share or expand are actually doing very well," says Greg Spevok, director of originations at Bear Stearns.

What happened last fall, explains Spevok, was the capital markets dislocation caused by a combination of factors exogenous to the industry and "unlikely to be repeated at least anywhere near the degree that occurred in late 1998."

He continues, "At that time, there was tremendous yield available and that brought demand. We have a much more stabilized market now and yields on investments have fallen. Some of the players that came in and garnered additional market share are unlikely to sustain it as yields have once again come to a more reasonable level."

The survivors in the CMBS industry, says Spevok, will be "the larger Wall Street, fixed-income houses."

Other survivors will include the big commercial banks, many of which have launched their own conduits. Of the top-21 loan contributors to CMBS transactions in 1998, according to Commercial Mortgage Alert, six companies were commercial banks: NationsBank ($2.6 billion), Chase Manhattan ($2 billion), Citicorp ($1.412 billion), Wells Fargo ($1.366 billion), First Union ($1.346 billion) and PNC ($808 million).

Merging success Last year, NationsBank and Bank of America merged. On a combined basis, the new Bank of America did about $55 billion in commercial mortgages. It also did four securitizations, including the landmark $1.6 billion issue in November that was the largest sole managed debt deal ever done by a commercial bank of any asset class. Bank of America will do about the same volume of originations in 1999 as it did the year before, while securitizations in 1999 could leap to $8 billion.

"To make this business work you need different elements," says Ken Rivkin, a Bank of America managing director. "You need low-cost capital, underwriting credibility and a source of origination. While you can go out and buy originations, it is less cost efficient to do that. So if you have an existing real estate department that can keep the leverage off and originate through that, it is much more cost effective."

Rivkin believes there will be a further shakeout. "Certain firms that have a strategic reason for being in this business will continue and other ones that view this as a short-term, profit-maximizing machine will not."

What also helps a major commercial bank is that the lines between it and an investment bank have blurred. Some commercial banks such as Chase Manhattan, in some regards, resemble investment banks. "The fact that you are a bank and you know how to deal with bank clients and the fact that you are also an investment bank and can bring the best of capital markets to clients is very unusual," says Pat Micka, head of Chase Manhattan's CMBS origination and servicing program.

"We are finding in the current environment, absent the disruption of last year, there are fewer players," Micka says. "Also, there is a certain comfort level that borrowers have with respect to dealing with a commercial bank (as opposed to an investment bank conduit) that serves us well. People who would not have necessarily brought us transactions last year are now adding a Chase Manhattan proposal to the transaction."

Rochelle Dobbs, who heads production for Chase Manhattan, observes the market has changed in 1999 from just a year ago. "We had a tremendous pipeline of deals coming into 1998 but because of the distraction in the marketplace last year, the pipeline in 1999 is very small - so it is really like starting from scratch. In January and February, people were still rethinking what they were going to do after last year. Given the sources of capital in the market, we are seeing a lot of CMBS from non-traditional borrowers."

Midland Loan Services Inc. was acquired by Pittsburgh-based PNC Bank last April and together it has become one of the largest CMBS servicers with a portfolio of more than $40 billion. In 1998, it added $23 billion of new servicing. The company also originated just under $1.4 billion of loans and expects to push that number slightly to over $1.5 billion this year.

"Our view has always been that to participate in this business you have to be vertically integrated with origination, securitization and servicing," says Stacey Berger, Midland's executive vice president. "We always viewed banks as being the really long-term, dominating players in the business because they have the capital and they have an historic real estate credit culture."

Berger adds, "On the private-finance side most of the increase in bank activity has been conduit activity. If you look at what Wells Fargo, Chase Manhattan, First Union and Bank of America are doing, the growth in their business has primarily been on the conduit side. In addition, all four of those institutions and PNC are significant project lenders. All should do about the same level of business in 1999 that they did in previous years - not any significant increase."

Coping with growing pains The CMBS market, despite its rapid growth, is still a young sector, says Joseph Rubin, national director of E&Y Kenneth Leventhal Real Estate Group's Financial Institutions practice. "Real estate players are just beginning to learn how to operate in a capital-markets environment. When you bring Main Street and Wall Street together, liquidity and investor perceptions become as important a driver of real estate values as location."

According to E&Y Kenneth Leventhal, lessons learned last year about the CMBS market include:

* The CMBS market requires a renewed commitment to quality underwriting. Industry leaders must step up and sponsor the development of standardized computations for Underwritten Net Operating Income.

* Issuers need to refine their origination strategies. Projections of profitability must reflect hedging costs and the interval from loan closing to pool securitization must be shortened to reduce exposure to spread risk.

* Issuers and investors must look beyond CMBS to recognize broader trends in the capital markets.

* Special servicers may be a weak link in the structural protection offered to investment-grade CMBS investors.

* To maintain liquidity, issuers must demonstrate the quality of their loans to buyers of non-investment grade paper.

There are still a lot of investors in the market this year, even though demand is off, Rubin adds. "After last fall, the issuers and investors realized that they haven't really figured out how to price risk in these securities and that is a major issue as there are a lot of risks here."