Commercial mortgage rates in early April were little changed from thirty days ago, according to the Barron's/John B. Levy & Company National Mortgage Survey of lenders and investors in the commercial mortgage-backed securities (CMBS) and whole-loan market. The relatively stable mortgage rates masked a spread increase of from .05% to .10% on the whole-loan side. Institutional lenders were intentionally trying to widen their spreads and, in general, found relatively little borrower resistance given the low levels of the current interest rate market.
Low leverage transactions - those with loans-to-value of 50% to 60% or less - continued to be highly sought after by the institutional community. Notwithstanding lender demand, a number of survey members noted that they were no longer offering spreads below 1.0%, for even the most conservatively underwritten transactions. Until recently, spreads in the .80%-1.0% range, though by no means common, were available for extremely conservative transactions. The floor has now seemingly moved to 1.0%, which, given today's rates, still offers borrowers a coupon of 6 3/4% or even less!
Lenders continue to talk about the seemingly inexorable decline in underwriting standards. The buzz in early April was about so-called "amortization creep." Commercial mortgage loans generally amortize over a maximum term of 30 years, with the exception of apartment loans underwritten and guaranteed by HUD which carry amortizations of 35-40 years. Now, amortizations in the 31 year range are available in selective instances. Although the longer amortization appears to most to be no big issue in and of itself, lenders are fretting about whether this is merely a hole in the dyke or whether the dyke is already broken.
The CMBS market ended the first quarter in record-breaking form. First quarter volume estimates range from $19 billion to $21 billion, which is greater than total new originations during all of 1995! At the quarter's end, a number of huge transactions were in the market, including two securitizations led by Merrill Lynch totaling some $1.7 billion, one conduit offering co-led by Deutsche Morgan Grenfell and Morgan Stanley for $1.8 billion, and a $3.7 billion thriller led by Nomura and Morgan Stanley.
The Nomura/Morgan Stanley deal was far and away the largest CMBS transaction ever. Because it came at the end of the quarter and was competing with several other new offerings for investor attention, spreads were materially wider than many observers might have expected. The largest triple-A tranche - $1.8 billion - carried a weighted average life of almost 10 years and was priced at .81% over Treasuries. The rest of the tranches were priced over longer-term 15-year paper which also caused spreads to appear to be wider than some might have expected.
But the talk on the Street wasn't about either the deal's size or the required spreads, but rather about a groundbreaking Nomura structure which, frankly, had heads spinning at most of the main Wall Street houses. In connection with the origination of 69 of the mortgage loans, which represented 46% of the initial pool or $1.7 billion, Nomura funded at closing to each borrower a premium in addition to the principal balance of each loan. This "premium," which investors claim was not originally disclosed in the red herring, averaged 8 1/2% of the affected loans. These so-called "buy up" loans, as they are known in the trade, require the borrower to pay a higher mortgage rate than the market rate in return for the premium payment. Nomura in turn used the higher rates to form two large interest-only strip classes. The borrower was obligated to pay back only the initial loan amount and, as a result, the loans-to-value did not reflect the premiums. As a result, rating agencies did not require increased subordination levels as they might have had the combined amounts been shown as a recorded lien. This ingenious strategy caught most competitors flat-footed. On the rating agency side, Joe Franzetti, head of real estate at Duff & Phelps, which rated only the triple-A tranches, stated that this "new practice creates investment risk for the interest-only strip holders and a credit risk for all tranches due to the lower debt service coverage ratios." Nevertheless, this new method of obtaining increased leverage without upsetting loan-to-value ratios will surely find other advocates.
This month we're pleased to begin a new table which reflects the increased prominence of the CMBS market. We will, of course, continue to follow the whole-loan market in much the same form as in the past. On the CMBS side, with the help of a number of major Wall Street CMBS traders and investors, we will be showing CMBS spreads for typical new originations. We'll also show the previous month's spreads in order to give a sense of direction. As with any new idea, we welcome your suggestions and ideas at our World Wide Web site: www.jblevyco.com.