By mid-fall, commercial mortgage rates had fallen to their lowest level this year, according to the Barron's/John B. Levy & Co. National Mortgage Survey of more than 30 participants in the commercial mortgage-backed securities and whole-loan markets. Even though the borrowing market viewed the lower rates positively, there was no apparent stampede to take advantage of them.

The end of October saw the launch of the year's second largest CMBS transaction - a $1.3 billion offering led by Donaldson, Lufkin & Jenrette, Prudential Securities, Credit Suisse First Boston and Salomon Smith Barney. The collateral included more than 240 properties. Slightly more than 30% of the pool was composed of multifamily loans, and almost 11% were thought to be of investment-grade quality by the rating agencies. The $790 million class A-1B, rated triple-A, was three times oversubscribed, which led many would-be buyers to receive dramatically fewer securities than they might have liked. At least two extremely large orders contributed to the over-subscription: a $500 million order from Freddie Mac and a $200 million order from Merrill Lynch Bank and Trust Co. Freddie Mac has been a huge player in the CMBS arena in the past and was clearly attracted by the high percentage of multifamily loans included in the collateral. Due to the strong market reception, the pricing on the A-1B class was set attractively at interest rate swaps plus 0.39%.

Virtually in the market at the same time was an $890 million deal with collateral from Bank of America and Hypo Vereinsbank. The reception, however, was quite different. The A-2 class, rated triple-A, had original price guidance in the range of interest rate swaps plus 0.37% to 0.39%, but when the books closed, the price had widened to interest rate swaps plus 0.40%. Buyers seemed unimpressed with the collateral, which included several loans where the sponsors had either previously filed for bankruptcy or had received convictions for securities violations.

Despite the fact that corporate bond spreads have widened materially, the CMBS market continues to do well. In fact, it's almost a case of the "haves" vs. "have-nots." Bond buyers have avoided corporate bonds due to numerous corporate earnings surprises as well as event risk, which includes such bankruptcies and corporate breakups. AT&T's pending breakup is but one current example. CMBS, along with other structured finance products such as credit cards and receivables, offer diversified credits. CMBS also is benefiting from strong liquidity and low defaults in the underlying loans. More on delinquencies a bit later.

As J.P. Morgan's Pat Corcoran put it, "The CMBS market is no longer using corporate bonds as an indirect proxy for its credit risk, but is instead - for the first time - beginning to trade on its own very positive property market fundamentals." But the very clear disconnect between corporate bond prices and CMBS prices has led more than a few people to scratch their head in amazement wondering when the tide will turn. As BlackRock's Steve Switzky puts it, "CMBS should reflect some of the weakness evident in the corporate market, especially with much of the CMBS market trading above par."

As we noted earlier, CMBS delinquencies are running at low rates, which was confirmed by the latest Giliberto-Levy Commercial Mortgage Performance Index. Credit losses for the past 12 months are an almost nonexistent 0.09%, below the previous best, which was registered in 1982. Commercial mortgages for the third quarter also performed quite well with a total return of 3.52% vs. the Lehman Brothers' duration-adjusted Baa Bond Index of 2.27%. For the same period, investment-grade CMBS recorded a return of 4.04%.

On the whole-loan side of the equation, insurance companies are beginning to see direct price competition from the CMBS market. A number of insurance companies are pricing their commercial mortgages based on a corporate bond index plus an arbitrary spread. Although this works when corporate bonds are priced within a normal range, the recent spurt in corporate yields has forced a number of insurers to price their mortgages at levels equal to or higher than those offered by CMBS players. To be sure, this may not last long, but it has put insurers in an uncomfortable position, as they usually are able to price their loans at lower rates than are offered in the CMBS arena.

On the loan origination side, most life insurers appear to be close to finishing their program for the year, and it's a good thing that they have. Despite rates drifting down, loan demand is moderate at best. Borrowers suspect that the coming slowdown in economic activity will lead to even lower rates in the future and seem to be in no hurry to lock in current rates.