After a white-hot pace of issuance in March, new offerings of commercial mortgage-backed securities have practically disappeared, according to the Barron's/John B. Levy & Co. National Mortgage Survey. But that's all about to change. Citigroup reports that some $43 billion in CMBS is scheduled to come to market before the second quarter is over.

Domestic first-half volume in CMBS is expected to total $103 billion, 28% more than in the same period last year. But activity in 2005 was heavily concentrated in the second half, so Citigroup's full-year forecast is just slightly ahead of the $180 billion record set last year.

Bankers and traders are on the hunt for any loan that sports some extra yield. In fact, the market today will finance anything as long as it's tied down. A brief gander at some recent transactions shows loans on truck stops, land (zoned and not zoned) and even an offering devoted solely to church loans. Can we soon expect speculative building of houses of worship?

Underwriting still slipping

Last fall we expressed hopes that underwriting would stop deteriorating and, in fact, might even become slightly stricter. We were wrong. With higher Treasury yields, developers and bankers have become more creative at finding ways to maximize leverage, even though debt-service coverage ratios are shrinking.

Just last year, standard loans carried a debt-service coverage level of 1.20. Simply put, the net operating income was 20% greater than the required debt service. That level has now shrunk to 1.15 — often as low as 1.10. Adding insult to injury, the coverage is now computed using interest-only debt service, because some 70% of securitized debt requires payment of interest only.

A few loans are consciously underwritten with a debt-service coverage of less than 1.0. To be sure, these transactions come replete with the borrower having significant cash in the project, making him less inclined to default. But when net operating income is less than the required debt service, it doesn't bode well for future delinquencies.

In late April, Moody's Investors Service examined the apartment sector, which has generally been perceived as a darling of the investment community. The rating agency analyzed apartments by year built and came up with some surprising conclusions.

Apartments built in the 1940s and 1950s were performing well, with delinquencies at 60% or less of the average for the sector, perhaps because they may have benefited from either a major renovation or an attractive infill location.

The delinquency rate on apartments built in the 1960s and 1970s was some 60% higher than the sector average, or, as one wag put it, “higher than many Woodstock participants.” The data suggests that those apartments may be near the end of their intended useful lives, or might be in need of a major upgrade to stay competitive.

Wall Street innovation

Triple-B spreads have been in a freefall of late, tumbling from 125 basis points, or 1.25 percentage points, over benchmark interest-rate swaps as recently as late February to 80-85 basis points today. The decline stems from a buying binge by originators of collateralized debt obligations and of investments known as real estate mortgage investment conduits (REMICs).

To get a better understanding of the forces at work, take a look at a current offering from CIBC and J.P. Morgan. The issue, styled RR1, is a $524 million REMIC consisting of 83 classes of securities from 53 CMBS offerings. Most of the collateral is new — $430 million of the deal having been originated in 2005 and 2006.

Some 90% of the collateral is rated triple-B-plus or lower, with the remaining securities rated from double-A minus to single-A minus. Using common slicing and dicing technology that Wall Street has mastered, the 83 securities are structured into an offering in which 82% of the new security is now rated triple-A.

To be sure, the REMIC structure offers increased diversity of cash flow, which is no small attraction. Expect buyers to stand in line to buy the new pool. The triple-A's will be priced 10-12 basis points wide of standard CMBS offerings.

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

Selected CMBS Spreads*

	To 10-year U.S. Treasuries
Rating	5/1/06	4/3/06
AAA	74-75	79-80
AA	85-86	92-93
A	95-96	102-103
BBB	136-141	144-149
BB	290-300	290-300

Whole Loans*(Interest Rates)

	Prime Mtge. Range	Prime Mtge.	Prime Mtge. Range
Term of loan	5/1/06	Rate	4/3/06
5 years	6.01-6.11%	6.06%	5.89-5.99%
7 years	6.05-6.15%	6.10%	5.95-6.05%
10 years	6.16-6.26%	6.21%	5.97-6.07%
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.

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