The role of commercial mortgages in an insurance company portfolio is the subject of a recent report issued by the Securities Valuation Office of the National Association of Insurance Commissioners (NAIC). The report, a copy of which has been obtained by Barron's, was prepared for a Feb. 7 meeting in Chicago. The meeting was intended to be a discussion between regulators, insurers and other interested parties about how to deal with the vastly complicated issues surrounding commercial mortgage-backed securities, loans to real estate investment trusts (RE-ITs) and so-called hybrid transactions.

As we reported in Barron's, Dec. 5., 1994, the NAIC started the discussions by requiring that a Taubman Realty Group debt offering on Lakeside Mall in Detroit be reported as a mortgage, as opposed to a bond. Industry analysts, at first blush, believed that the ruling was meant to deal only with single-asset transactions and was unlikely to affect the vast bulk of commercial mortgage-backed securities and loans to real estate entities. But the "Carcano Report," named for its author, Robert Carcano, leaves no doubt that the discussions are not to be limited to single-asset transactions. The report indicates that regulators should deal with a much broader range of activities to include all commercial mortgage-backed securities and debt REITs, whether secured or unsecured.

The report offers convincing evidence that the commercial mortgage arena is new and relatively unsophisticated when compared with the single-family mortgage arena, where data is a great deal more plentiful. Although attempts have been made to "bridge the gap" and make securitized commercial mortgages less risky than their whole loan counterparts, they are still not as secure as bonds and, therefore, may well require more reserves than their corporate bond and single-family securitizations. At present, commercial mortgage-backed securities rated single "A" or higher require only one-tenth as much capital as commercial mortgages in their whole loan form. To be sure, Wall Street has used this huge capital difference as a strong argument for insurers to buy the securitized version of commercial mortgages.

The report states that it is "difficult to conclude that securitization protects against real estate risks sufficiently to suggest that real estate and securities are entitled to the same regulatory premium exacted for bonds." Therefore, it suggests that perhaps commercial mortgage securities should carry a capital requirement which would be more than for bonds in general, but less than for commercial mortgages.

Items that were expected to be discussed at the meeting include an assessment of whether office and hotel properties, because of their more volatile nature, should qualify for the proposed lower capital requirements. Additionally, the study suggests that the NAIC should develop a new policy for REITs. To date, rated unsecured REIT debt and mortgages issued by REITs have qualified for treatment as bonds.

Analysts familiar with the studious nature of the regulatory process have suggested that the Feb. 7 meeting, though clearly a good first step, will probably raise more questions than it answers. The NAIC would like to develop guidelines as soon as possible in order to provide proper guidance for insurance companies for the 1995 calendar year.

In the conventional commercial mortgage arena, the "C" word -- competition -- is on everyone's lips these days. Lenders continue to flock to the industry with money to lend on a fairly stable number of transactions. One reason for this continuing interest in commercial mortgages is that the industry turned in a stellar performance for 1994 when compared to corporate bonds. The Giliberto-Levy Commercial Mortgage Performance Indexsm showed a total return for 1994 of 6.32% vs. a -1.98% for the Lehman Brothers "Baa" Intermediate Term Bond Index. But for those with short memory, commercial mortgages are no easy road. Imbedded in the Giliberto-Levy Return for 1994 is a default and delinquency cost of 1.63%, a whopping charge by any standards, though down appreciably from the 1993 charge of 2.1%.

Among the brand-new entrants to the institutional lending market is GE Capital. Long known as an aggressive and sophisticated tender, GE has generally tended to seek out highly leveraged transactions along with their commensurably higher yields. But all that appears to be changing as GE broadens its horizons. In a project called "Briarcliff," GE Capital has announced that it will seek to lend $1 billion this year in a market which has heretofore been dominated by insurers, pension funds and Wall Street. At least for starters, the loans will be limited to 70% of value and will carry an adjustable rate, which begins at 7 3/4%, GE expects to expand into the fixed-rate lending arena some time in the future.