Commercial mortgage interest rates were little changed at the beginning of fall from their pre-Labor Day levels, according to the Barron's/John B. Levy & Co. National Mortgage Survey of more than 30 participants in the market for commercial mortgage backed securities (CMBS) and traditional whole loans.

Though interest rates showed little movement, the market was abuzz with a flurry of activity. Analysts noted that they expected September and October to be chock full of new business, and surely September did not disappoint. No less than nine major deals came to the market for a total of $6 billion, with virtually all the major CMBS players participating.

Before the flurry of activity began, investors expressed some concerns that spreads would have to widen in order to absorb the expected new supply. Spreads during the summer had been relatively stable, but then again, new supply was nothing to brag about. Despite the prophesies of rain clouds, spreads actually tightened by some 2 to 3 basis point (bps) at the triple-A level. This tightening occurred, according to some traders, because deals were spread evenly through the month, which gave the market a chance to react in an orderly fashion to each new transaction.

Perhaps that was true, but a few skeptics hinted that the presence of a new, large, triple-A buyer - Merrill Lynch Bank & Trust - was more than a minor factor in keeping spreads at attractive levels. Industry observers noted that the bank purchased a $300 million block of the $1 billion Lehman Brothers/UBS securitization and $200 million from the Chase/Heller/GE offering. Regardless of the cause of the tighter spreads, the quarter ended on a significantly more positive tone than most had suspected before Labor Day.

On the CMBS side, the market continues to be tiered, with so called "tier-one" deals being originated by a select group including Bear Stearns/Wells Fargo and Chase Manhattan. The tier-two players include most of the other conduit originators including DLJ, JP Morgan and Lehman Brothers. In the minds of institutional buyers, tier-one players are thought to have a better "credit culture" than their tier-two brethren. As a result, the tier-one players are rewarded with both better spreads for their securitizations and lower subordination levels from the rating agencies.

To be sure, tier-two competitors are nothing but jealous, and note that they are just as good at underwriting. In fact, a look at two recent securitizations may prove that there is less to the tier-one/tier-two difference than meets the eye.

At the end of September, JP Morgan and Salomon Smith Barney brought to market a $738 million securitization where the triple-A rated, A-2 Class sold at interest rate swaps plus 40 bps. Less than a week earlier, Chase Securities brought a $776 million offering to the market where the triple-A rated, A-2 Class sold at a significantly tighter spread of interest rate swaps plus 37 bps.

According to Fitch Investor Services, the JP Morgan/Salomon transaction showed a stressed debt-service coverage of 1.16, compared with an almost identical 1.15 stressed debt-service coverage level for the Chase offering. Some of the underlying underwriting standards, however, were quite different. For example, Chase required tax escrows for only 59.5% of the collateral it contributed, while the JP Morgan/Salomon transactions had tax escrows for 98.3% of their collateral. For insurance escrows, the score was Chase 0% and JP Morgan/Salomon 97.9%. With respect to obtaining recourse for fraud and other so-called "carve-out provisions," Chase chose to look only to the borrower, generally a single-purpose entity, while JP Morgan/Salomon obtained recourse from principals on 93% of their transactions.

Although September securitization was surely healthy, the industry continues to struggle with overcapacity. CMBS volume for 2000 will be materially down from 1998 and 1999, and consolidation seems inevitable. Corporate mergers should help matters somewhat as the upcoming mergers between JP Morgan/Chase, UBS/Paine Webber and DLJ/CS First Boston will reduce six competitors to three. As Banc One's Eric Hillenbrand stated, "this shrinkage by accident will have a positive impact on total CMBS operations."

The overall commercial real estate market continues to be strong, and nowhere is that more apparent than in subordination levels. Subordination levels show the percentage of securities below the triple-A level. Higher subordination levels offer the triple-A holders more security. But recently, subordination levels have been dropping off a ledge. For example, Bear Stearns and Wells Fargo teamed up to offer another round of their highly regarded partnership. The $793 million securitization was well received, as always, despite the fact that the triple-A subordination levels at 16.5% were the lowest ever obtained by a conduit operator. This contrasts with the 19.5% level in their last joint offering.

The breathtakingly low levels have more than a few buyers gasping for breath and wondering whether the new, tighter levels are due to the ability of the conduit operators to shop for the best ratings and subordination levels from the three major ratings houses. The answer from conduit operators in general is that the lower levels come not from shopping for ratings, but rather from a better screening process on their part as well as subordination levels that initially were too high.