Contagion, Plus

Joseph Gyourko, chairman of Wharton's real estate department and director of the Samuel Zell and Robert Lurie Real Estate Center, says the CMBS market "took a huge hit around the same time as the credit crunch last August," and the data bears that out.  Blue-chip
CMBS went from 26 basis points over swaps in July 2007 to about 70
basis points in September. Spreads eclipsed the 100 basis points
threshold in late November and ballooned to their widest point in March
2008.

"Some of it was contagion from subprime," Gyourko says. "The blowup
in the housing market affected the commercial market, mostly for not
very good reasons. Most commercial loans on shopping centers, office
buildings and the like had nothing to do with the residential side.
Some contamination was not justified, [and the result was] a dramatic
widening in spreads. I think, though, there is one good,
fundamentally-based reason why CMBS went down," he adds. "In 2006 and
2007 in particular, the underwriting deteriorated. Loan-to-value ratios
went up, and debt service ratios went down. People decided that there
was too much commercial [MBS] out there." Gyourko predicts that the
CMBS market will be fine, eventually. Deals that are soundly
underwritten, with reasonable assumptions on rents and values, will
come back, he says. "We need a securitized market."

Orest Mandzy, co-owner and managing editor of Commercial Real Estate
Direct, agrees. He's been a close observer of the CMBS market since it
started to blossom in the mid-1990s, largely in response to the
savings-and-loan crisis. The fundamental problem between the S&Ls
and commercial mortgages was that a typical loan of 10 years on an
office building was being financed with short-term money, Mandzy says.
Pension funds and insurance companies, because of the long-term nature
of their businesses, were a much better match, he adds, but they lacked
the capacity to handle the volume of commercial loans. Securitization
was the answer -- the selling of bonds with average lives of 10 years,
backed by 10-year mortgages.

"It was a perfect match," Mandzy says. "It was good for everybody.
Instead of pension companies writing a mortgage, where you could suffer
a loss on a direct loan, in securitization you could layer the risk. If
you don't want much risk, you could buy a triple-A loan. And then there
are a lot of classes below that, which would suffer first. The market
opened up a pool of potential investors, and over the years, as more
came in, they recognized it as a very stable asset class. Between 1995
and 2007, there have not really been any major defaults in CMBS."