So much for sleepy Januarys. The commercial mortgage business started this year at warp speed, reports the Barron's/John B. Levy & Co. National Mortgage Survey. Both institutional lenders and CMBS providers alike are acting as if 2005 will set yet another volume record. As Aetna's Managing Director Pete Atwood puts it, “We're sharpening our pencils quickly this year.”

Leading the charge in late January was a monstrous securitization from Goldman Sachs and RBS Greenwich Capital, weighing in at a hefty $3.6 billion. This transaction — the second largest CMBS securitization ever — was only a tad smaller than a $3.7 billion offering from Nomura Securities at the height of the market in 1998.

Buyers were drawn by the transaction's size since the large tranches virtually guaranteed liquidity. For example, the $1.1 billion A-2 tranche was heavily oversubscribed and sold to almost 40 separate accounts. The buying populous included Freddie Mac, which pulled down a dedicated class of multifamily loans totaling some $140 million.

The deal wasn't devoid of underwriting concerns, as some 63% of the loans were interest-only for either part or all of the term. But buyers seemed to be oblivious to that fact, as the spread on the larger tranches tightened from the underwriters' original estimates. “There's a lot more greed in the market than fear,” notes Mitchell Kiffe, vice president of loan production at Freddie Mac.

Telltale Signs of a Frothy Market

As Peter, Paul and Mary might croon, “Where Have All the Good Loans Gone?” or so Fitch Ratings asked in a recent report. Fitch is concerned that recent underwriting trends in fixed-rate CMBS originations may well lead to higher defaults and losses in the years ahead. Perhaps the most widely discussed issue is the increase in interest-only loans as seen in the Goldman-Greenwich transaction.

Fitch notes that interest-only loans have risen from only 2.9% in 2001 to 36% in the last quarter of 2004, with one deal in 2004 having fully 72% of its loans interest-only. The interest-only period reduces amortization, which means that a larger amount of debt needs to be refinanced at the maturity, increasing the chance of either the loan being extended or placed in default.

The Fitch report also notes that there has been an increase in loans made to tenant in common (TIC) borrowers. TIC members are generally unaffiliated parties who are assisted by a syndicator in finding new properties in which to invest in order to defer their capital gains, known as 1031 transactions. Rating agencies are concerned that TIC borrowers will not be able to infuse new cash to correct any ongoing problems. Additionally, rating agencies indicate it is difficult to deal with multiple unrelated parties who may well have divergent long-term views.

When will reality set in?

Commercial real estate borrowers are reporting that lenders are willing to lend them higher loan amounts than they are soliciting. Rating agencies, institutional lenders and CMBS buyers are shivering at the thought. As Fitch Ratings' Managing Director Mary Metz puts it, “It will take a serious event — probably non-real estate — to bring reality back to the commercial real estate market.”

Loan delinquencies in the CMBS arena are declining at a rate that many would suggest is too good to be true. The decline is at least partly due to the “denominator effect.” The huge volume of new loans is added to the denominator and yet the loans are the least likely to default. Roger Lehman, director of CMBS research at Merrill Lynch, has come up with a credit-impaired rate that is calculated on a static pool and includes both delinquent loans and liquidations.

Lehman's credit default rate is now 3.38% of pre-2003 conduit loans, and he likes the trend. Loan-loss severities are down, just 27% in the second half of 2004 vs. almost 45% during 2003. Additionally, the credit-impaired rate since July has been increasing but at a decidedly slower rate. The loans that Merrill Lynch is tracking were closed well before the deterioration in underwriting standards, so sophisticated buyers shouldn't be putting the Fitch report in the circular file too quickly.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.

BARRON'S/JOHN B. LEVY & CO. NATIONAL MORTGAGE SURVEY

Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 1/31/05 1/10/05
AAA 61-62 66-67
AA 69-70 74-75
A 78-79 83-84
BBB 118-123 116-121
BB 280-300 300-315


Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 1/31/05 Rate 1/10/05
5 Years 4.90-5.00% 4.95% 4.87-4.97%
7 Years 5.09-5.19 5.14 5.11-5.21
10 Years 5.37-5.47 5.42 5.46-5.56
For loans of $5 million and up, on amortization schedules of 25-30 years that can be funded in 60-120 days with 0-1 point.


*in basis points, or hundredths of a percentage point