Party Over for Issuers of Mortgage-Backed Securities


The issuers of commercial mortgage-backed securities are facing their first financial crisis since the fledgling industry got its start almost five years ago. Spreads to comparable Treasuries on these bonds, which are secured by large pools of mortgages, are widening, and the tens of millions of dollars in profits they once generated have slipped away, leaving some companies in debt or barely breaking even.

Take the case of Virginia-based WMF Capital Corp., a publicly held mortgage originator. It recently posted a $30-million pretax loss on its sale of $691 million in commercial loans to Merrill Lynch & Co.

The loss was almost a knockout punch for WMF, considering its book value was $43.3 million. It had intended to sell the loans in a September offering led by Merrill Lynch. But, sources say, widening spreads--the difference between the interest rate on a comparable Treasury bond and the rate promised on these securities--forced a margin call on its line of credit and WMF was forced to sell the loans at a discount.

Analysts say it was the first time a major lender had stumbled in this business, and a signal that the nation's healthy real estate markets don't necessarily spell big profits for mortgage originators.

"This is the first shock to the system. The spread increases have been so dramatic nobody has priced in their system enough room for this," says John B. Levy, president of Richmond, Va.-based real estate investment bank John B. Levy.

The trouble began earlier this summer, when loans began flooding the market. Booming real estate markets and low interest rates boosted loans for the acquisition or development of apartments, hotels, and warehouses. The profitability of the new sector prompted investment banks and other finance companies to join the party.

The situation reached a peak this month as demand from mortgage real estate investment trusts, one of the biggest buyers, was cooling off as the appetite for their offerings abated and as an avalanche of commercial mortgage-backed securities began reaching the market.

In September alone, $15 billion in securitized loans were slated to hit the market, almost as much as the $17 billion sold in all of 1995, Levy says. By the end of this year, the total value of loans sold is expected to be $75 billion.

With so many offerings to choose from, and a dip in demand, conservative pension fund and insurance company investors who were spooked by the turmoil in the world markets and on Wall Street demanded and got higher returns for the same amount of risk.

The spread jumped from about 0.77 percentage points at the beginning of summer to 0.87 percentage points by August, then catapulted again between 1.20 and 1.25 points this month, according to a survey conducted by Levy's firm.

For originators used to taking a slim 1.5- to 2-percentage-point profit on these loan pools worth hundreds of millions of dollars, having to promise investors an additional 1 or 1.2 percentage points means the difference between profit or loss.

None of the big investment houses, including Merrill Lynch, will disclose how big an impact their troubled commercial mortgage-backed securities business has had on the bottom lines, which have already been battered by trading in emerging markets and other fixed-income securities. Many are having to sit on the large pools of loans until the market for them comes back.

Merrill Lynch's inventory of loans and mortgage assets ballooned to $7.6 billion in June from $4.3 billion at the end of December. Its inventory of trading assets also surged during that time to $11.2 billion from $7.3 billion.

Many have slowed their lending, and if the losses continue, some may even choose to get out of the business, says Los Angeles investment banker George Smith.

For borrowers, these problems may mean disruptions in loan processing, stricter lending guidelines and some renegotiation, as lenders adjust interest rates to accommodate market fluctuations, analysts say.

"They're going to have to pay a higher rate or fees and put up more equity," says Bob Siegal, a partner with Arthur Andersen in Houston.

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