Investors in loans on commercial real estate — insurance companies, pension funds and Wall Street firms — continued competing for business in January, squeezing spreads between interest rates on commercial mortgages and rates on Treasuries. According to the Barron's/John B. Levy & Co. National Mortgage Survey, the narrowing was only slight on loans representing 75% to 80% of property value.

But for institutions seeking low-leverage mortgages — generally defined as 65% loan-to-value or less — competition narrowed spreads to as low as 75 basis points, or a scant three-quarters of a percentage point, over Treasuries. The spread had recently been around an already thin 85 to 90 basis points.

Cautionary memo

It appears that real estate lenders have once again become complacent about credit, having shown some concern last fall. As Moody's Investors Service noted in a report issued at the end of January, some lenders “are unapologetically making high-risk loans” and defending the practice by saying that's where the market is.

Capitalization rates — the inverse of a price-earnings ratio — are now at their lowest levels in the 40 years that the American Council of Life Insurers has been keeping track. In response to the high real estate values and leverage levels flowing from these record-low cap rates, Moody's notes that it has been raising subordination levels, a measure of the safety cushion under triple-A bonds in a mortgage-backed security. Other major rating agencies seem to be reading from the same sheet of music.

Federal regulators of financial institutions are also reading from the same score. In January, the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Office of Thrift Supervision issued a joint memo about concentrations in lending on commercial real estate. They noted that some institutions have “high and increasing concentrations of commercial real estate loans,” and the agencies are concerned that this may make institutions vulnerable to the normal commercial real estate cycles.

The agencies are looking to identify banks and thrifts that might be subject to tougher supervisory scrutiny in the future. The agencies issued a similar notice in 1989, which many observers believe led to the acute shortage of capital in the early 1990s. To be sure, the markets are dramatically different today, including a Wall Street presence in the form of commercial mortgage-backed securities (CMBS) — a presence that was practically nonexistent in '89. But this notice is clearly a shot across the bow to a number of bankers.

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

Fast start to 2006

On the CMBS side of the market, February was expected to experience a heavy flow of new issues. As many as 10 separate securitizations amounting to some $25 billion were originally expected to come to market, though a few of these may be pushed back into March. With a record number of new securitizations planned for the first quarter, many buyers are wondering who will absorb this tsunami of CMBS paper.

In late January, a member of Freddie Mac's highly regarded CMBS team, Greg Murdock, was hired by Fannie Mae. To date, Fannie Mae has not been a CMBS buyer and has looked to its delegated underwriters and servicers to give it access to the commercial mortgage market.

Although it's not clear how active in the market Fannie Mae will become — or even whether it will be a buyer of CMBS — Murdock could put it on track to become a major force, and even replace Freddie Mac as the largest single buyer and owner of such securities.

On the whole-loan side of the ledger, commercial mortgages turned in a strong performance in 2005, generating a total return of 3.35%. This was well shy of the 5.13% registered in 2004. But while the absolute return wasn't striking, it shellacked investment-grade CMBS, which garnered a 1.83% return and, in turn, outpaced duration-adjusted triple-B corporates, which recorded a minuscule 0.50%, according to Lehman Brothers. The triple-B corporate returns were clearly affected by the poor credit performance of both General Motors and Ford.

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