Judging by the long list of casualties, the sudden reversal of fortune for commercial mortgage-backed securities (CMBS) last fall caught many participants flat-footed.

This is a bit surprising because only a few years earlier we had a similar meltdown in other fixed-income mortgage products, namely derivatives, exposing the perils of a business built on profit margins that were dependent upon high leverage provided by Wall Street.

Many have attributed the CMBS crash to the closer correlation of real estate and the capital markets today. This is true to a point. Certainly, we see sharper, more abrupt swings in confidence based on global events and breaking news. No one could have foreseen that events so removed from U.S. real estate could have caused such a precipitous fall. Moreover, no one could have predicted that falling Treasury rates - a result of a flight to quality - could have impacted so many fixed-income securities so drastically.

That said, we should have recognized the inherent risk associated with loan aggregation - the time between originating fixed-rate loans and selling securities in the secondary market.

Last year's CMBS turmoil parallels in many ways the scenario that occurred with derivatives. In 1996, Brookings Institution scholar Martin Mayer applied the instability hypothesis, which states, "Success breeds excess, which breeds trouble to derivatives, creating three laws to explain the meltdown of these sophisticated instruments."

When the whole is valued at a price less than the sum of its parts, some of the parts are overvalued. In other words, multi-class securities can be cut profitably into separate tranches because there are enough buyers who don't understand the risks fully, especially when they are tempted by the reward of high returns.

Segmenting value segments liquidity. We generally think of segmenting value as segmenting risk, but it also segments liquidity. The more narrowly tailored a financial instrument is, the less likely it can be sold in a crunch. Market risk, therefore, is made more dangerous by segmentation risk.

Risk-shifting instruments ultimately transfer risks to those less able to bear them. This was particularly true in the CMBS market when many were unable to meet margin calls, refinance debt or sell lower-rated securities. Many of those hardest hit were those who did not have the capital to warehouse loans, forcing them to sell at a loss.

The root of the CMBS markets problem in 1998 was a mispricing of risk related to volatility in the capital markets. For years, bond spreads contracted. When spreads widened, no one thought to build in a cushion or large enough cushion for protection.

Now that everyone recognizes the mispricing of capital market risks, margins will have to increase to account for the risk. In the infancy stage, there was an arbitrage profit that came from originating the loan at a higher rate than it was funded. Now, participants will look to create long-term value through loan servicing and investing in subordinated debt.

The market will change in other ways. The playing field has already begun to contract. Increasingly, bondholders base decisions on credit quality and reputation, asking questions such as, which conduits have a record of conservative loan underwriting, which can service loans and retain an investment, and which have a strong balance sheet.

Over time, this will lead to a differentiation of issuers, servicers and rating agencies. Investment banks also will act less as a principal and more as an agent responsible for structuring and distributing securities.

The market has since recovered as the cost of funding has decreased, but many believe the market is still not fully pricing the potential impact of negative credit risks (i.e. a downturn in the economy). While that remains to be seen, at least CMBS participants finally have a taste of what to expect in a downturn.

If you have an idea for a Last Word column, please send a brief synopsis of the column via e-mail to ben_johnson@intertec.com.