With so much media and federal regulatory attention focused on the global credit crunch, especially the securitization of massive pools of home loans, there has been little notice of what’s been happening with the market for commercial-mortgage backed securities, a younger cousin in the structured finance family.

“It’s pretty much gone,” says Wharton real estate professor Todd Sinai, speaking about the current state of CMBS issuance. “The liquidity crunch is across the board.”

The market for CMBS — packages of pooled loans backed by mortgages on office buildings, industrial properties, malls and other retail centers, and apartment buildings — has been ravaged by market conditions since last fall. In the first six months of 2007, 39 deals totaling $137 billion were brought to market and successfully sold, from the highest rated (triple-A) bonds down to the riskier, higher-yielding and lower-rated classes of bonds called B-pieces. Through mid-July 2008, only nine deals totaling $12.1 billion have been completed, a drop in issuance of more than 90%. No CMBS deal has been completed since a $1.27 billion offering from Banc of America Securities on June 19. There are currently no CMBS deals on the market.

Sinai believes there is little interest in the CMBS packages because they include both very secure and very risky bonds at a time when the market for the riskier elements is practically non-existent. Like their residential mortgage cousins, the CMBS are packaged in tranches, or layers, to offer protection for some buyers and higher yields for others. Without a market for the high-risk, high-yield layers, the overall package can’t sell. What’s more, Sinai says, for those deals sold so far this year, prices have been based on very few transactions, further distorting the market that had been steadily growing and stabilizing during the past decade. Due to the inactivity, “You don’t even really know where the market is,” Sinai adds. “All of the CMBS issued this year [were underwritten] in 2007, and only got unloaded this year.”

CMBS prices have plummeted, while yields, as measured in basis points over swap rates, have skyrocketed. As the CMBS market expanded, investors drove up prices for 10-year triple-A rated bonds. In their headiest days, in the three years leading up to summer 2007, those bonds were yielding consistent and reliable returns for CMBS investors, according to data from Commercial Real Estate Direct, an online news and information service based in Newtown, Pa. But these same securities are quoted today at prices that market watchers say are severely out of proportion to their value. These prices, or “spreads,” are the difference between the swap rate on a bond and the yield on a government bond of the same maturity, representing the risk associated with the investment. The lower the number, the better the price (and the tighter the spread).

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.”

A Resilient Product

Location is just as important in the commercial real estate world as it is with homes. A key difference is that a building’s functionality and the reputation and track record of its tenants are what give it value for commercial investors, whether it’s a glistening new tower in Midtown Manhattan or a dusty warehouse just off the interstate in Nebraska. “In a commercial property, you have to underwrite what you think the cash flows are,” Gyourko says. “There are no cash flows on my house.”

Gyourko did choose his house, in part, because it’s in an excellent school district. But schools, the age of a house, its distance to the closest major city, roads and other factors are relatively intangible when compared to a commercial building’s measurable underlying assets. That office building in Manhattan, for example, has an easily accessed history of cash flow from tenants, who typically sign firm 10- or 15-year leases. In terms of where pooled securities get their value, the chasm between commercial and residential loans is significant. What they have in common is one thing: the word “mortgage.”

CMBS could be in uncharted waters with this year’s drought of issuance. Mandzy notes that the only truly comparable period was in 1998, during the Russian bond crisis. That, too, was a systemic credit crunch, as opposed to a collateral deficiency. Mortgages still performed well and there was not much collateral loss, though Wall Street flooded capital into Treasuries and all structured finance vehicles fell in value.

In 2005, Hurricane Katrina took a more direct swipe at the assets that backed CMBS bonds. “When Katrina hit, it proved how resilient and diversified the asset class was,” Mandzy says. “Three states were basically knocked out of line, with thousands of properties devastated. Defaults climbed substantially, but they still never reached 1%. That tells you something. Bond investors suffered only incidental losses on the lower-rated classes. But they were all prepared for this. When Katrina hit, they knew right away what would be problematic.”

Still, Mandzy and Gyourko agree that, like the residential side, CMBS deals were becoming looser, structurally. Top CMBS issuers, including Wachovia Securities, Credit Suisse First Boston, Deutsche Bank, Lehman Brothers and others, increased their offerings to meet bigger foreign demand for bonds backed by American properties. Hyper-growth in India and China, Mandzy notes, pushed the number of deals and their sizes upward.

“Loans were becoming generous,” he says. “There were some that didn’t need amortization, mezzanine financing [debt that can be converted to an ownership stake] was widely available, and you could buy commercial property for close to no money down in some places. Anything that was structured, investors were buying.” Also, an increasing number of loans were made based on projected, or pro-forma property cash flows, and not existing cash flows.

An indication of lax loan writing can be seen in the fact that more than $30 billion of all the commercial mortgages securitized in 2007 (about 16%) are on “master servicers’ watchlists,” meaning they have potential problems, according to analysis by Credit Suisse. The report says that, in contrast, $64.2 billion, or 12.3% of the $521.2 billion of mortgages securitized between 1996 and 2006, are on watchlists.

Simpler Is Better

Going forward, there will be a different underwriting standard, according to Gyourko. “We got into a situation where there was so much demand for yield that you could end up with a poorly underwritten product. And there would be some bond desk out there that would buy it. That’s going to go away.”

He also believes that buyers of higher-yielding CMBS tranches, the “B-piece buyers,” will be controlling the market. Since those buyers stand in the first-loss position if loans go bad, they historically have had the authority to “kick out” certain loans from CMBS deals, and therefore helped to shape the overall deal. In the future, Gyourko says, “it clearly is going to matter more to investors who they are.”

Changes may be in store for other players in the CMBS market as well. The ratings agencies — Moody’s, Standard & Poor’s and Fitch — have come under fire within the context of the housing crisis for the manner in which they operate and get paid. As for the fallout for CMBS, “I honestly don’t know, but something’s got to change, because they failed, and that process failed,” Gyourko says. Changing the “incentive structure” for the rating agencies has been talked about, such as having buyers pay for the ratings rather than the issuers. “More likely is that they [would] only rate simple, more transparent issues. That also tells you what CMBS will look like in the next few years — simpler, better underwritten, regular CMBS, as opposed to more complex [collateralized debt obligations].”

According to Mandzy, many in the industry feel the ratings agencies are being scapegoated, but that a perceived conflict of interest is a legitimate concern. Yet many institutional investors are restricted by their charters to buy only bonds rated triple-A by the agencies. “CMBS is probably the most transparent structured finance market that exists,” Mandzy says. “You do your due diligence based on data and how it did historically. In CMBS the data set is relatively robust, and at the end of the day you still have a property that generates income.”

In June, the Commercial Mortgage Securities Association (CMSA) announced that a study it commissioned found that CMBS were mispriced “compared to their fair value and returns relative to their risk.

“CMBS will perform well in a deteriorating recessionary environment,” the statement said. “Current spreads for most CMBS [past deals] are still far wider than their fair value, [which is] an irrational market reaction.”