Commercial mortgage rates continued their seemingly inexorable slide during December, according to the Barron's/John B. Levy & Co. National Mortgage Survey. The Barron's/levy 10 year mortgage rate, which today stands at 7%, was 9V4% exactly 12 months ago!

There is no question that the superheated market for commercial mortgages, which has existed since late last spring, is almost entirely the result of this in, credible rate decline. Virtually all of today's commercial real estate players were not around in the 1960s when rates were as low as they are now. Due to borrower demand, a number of large life insurance companies originated a record number of new commercial mortgage loans in 1995. The big question today is what can they possibly do for an encore!

For 1996, survey members seem to agree that inflation will stay in check, and interest rates will continue to stay in their current low range. This is especially true, since 1996 is a presidential election year. Because of the large number of consolidations in the insurance industry, including the acquisition of Connecticut Mutual by Massachusetts Mutual Life Insurance Co. and the New England Life Insurance Co. by Metropolitan Life, market analysts are predicting that commercial mortgage spreads will increase, because there are no significant new players entering the new market. Additionally, some institutions are projecting that their cash flows will be down, and thus, their appetite for mortgages will be reduced as well. On the opposite side, others note that prepayments are running at record high levels, which will force institutional lenders to originate a large number of new mortgages even though the cash flows from new product sales may be down. Regardless, it surely appears that 1996 will be another banner year for commercial mortgage origination.

The question of what is the "correct" spread for a newly originated commercial mortgage goes to the heart of a debate, which is just beginning to rage between the commercial mortgage securitization forces and those who originate whole loans for their own portfolios. Whole loans currently carry a more narrow spread than those loans which are securitized on Wall Street, leading each side to wonder who is right.

In an attempt to answer the question, a major investment bank analyzed the almost $1 billion securitization of Provident Life and Accident Insurance Co.'s portfolio, which took place in October 1995. This securitization was a well diversified pool of whole loans which had been originated by Provident and was thought to be similar to the types currently being originated by the insurance industry. The deal was done in seven tranches and was well received by the market. The securitization yielded an overall cost to Provident of 1.8% over comparable term Treasuries. This means that insurers would have to originate new loans with a spread of at least 1.8% in order to securitize their portfolios at par. Most current originations are being done substantially below that level, which seems to indicate a potential pricing problem in the whole loan market. Institutional lenders are quick to argue that they are allowed to buy and hold mortgages, and therefore, do not need a trading mentality when pricing the loans. Additionally, they note that most institutional buyers still do not have a high confidence level in either Wall Street's or the rating agencies' abilities to underwrite real estate. The pricing differences between whole loans and securitization come about because of this lack of confidence. As time goes on, this gap should evaporate. But for now, it's clear that there are still plenty of pricing inefficiencies in this huge $1 trillion market.

Not only was it a record year for new origination, but commercial mortgages turned in an extraordinarily strong total return as well. Based on the preliminary data from the Giliberto-Levy Commercial Mortgage Performance [Index.sup.sm], commercial mortgages for 1995 showed a total return of 17.3% after credit losses. This was their best showing since 1986. The Lehman Brothers Baa bond index adjusted for this same duration came in a modestly higher 18.37%. For the last three months of 1995 alone, mortgages overpowered bonds notching a total return of 5.29%, compared to 3.85%. The good news continued as default and delinquency costs continued a steep decline. For 1995, they ran at a total cost of 1.15%, which was less than half of the peak level reached as recently as 1993.

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