The CMBS credit story is solid for 2004, said Patrick Corcoran, head of mortgage research at JPMorgan Securities, who named the sector the premier safety play for the year. But is trouble up ahead?

"The big theme in 2004 is the safety play with CMBS as a high-quality swaps substitute with spreads similar to agencies," Corcoran said. Despite the competitive lending environment, discipline in the sector remains intact in both lending and property market pricing, Corcoran told the audience at the JPMorgan Structured Product Conference in New York last week.

"On underwriting, we've been in a very highly disciplined and credit-wary environment for the past 10 years, and so the differences in loan and deal performance have been minimized; the differences between shelves and lenders have been minimized," he said.

However, this could change as new players continue to enter the market to take advantage of excess returns. "Differences in underwriting results are likely to widen," he said. "Pay attention to those with solid track records." Discipline is especially critical in the realm of large loans, he said.

"The large loan component in conduit fusion deals has become larger," he said. "These lumpier deals are verging on a new product type." In order to maintain the relative advantage for large loans, analysts must insist on shadow ratings. "These lumpier new deals are more sensitive to the results of the largest loans and their performance," he said.

Investors speak out their fears

Meanwhile, investors sounded off during a panel discussion later in the afternoon.

"Leverage is very, very high," said Caroline Platt, CMBS analyst with GE Asset Management at the investor panel called Market and Credit Outlook.

She noted that the LTV ratio on most current presale reports is 90% or greater.

Extension risk is also something to watch, she said. "We are seeing a lot of refinance risk, particularly with rates being so low right now," she said. She added that a large number of deals were failing the refinance stress tests of her firm, and that the market was primed for significant extension risk in 2013 and 2014.

However, the more ominous specter of default risk is relatively low, she said.

"Although delinquencies are rising, defaults are not rising to the same degree. We are still a long way from defaults in the investment-grade sector, so that's comforting," Platt said. "But we prefer to see lower leverage."

"What I find really disturbing is that all this is happening at the same time that subordination levels are so high," said Mike Moran, a portfolio manager with Allstate Insurance Company. "You used to be able to stress these loans and still have a margin of error on the credit enhancement level. Today you can't do that. When three loans are upwards of 18% of a deal and you've got a 6% subordination level, there is no margin of error."

In addition, Moran voiced his concern over the impact that globalization could have on demand for CMBS. Commercial real estate is largely dependent on job growth for longevity, he said, and the environment doesn't appear particularly favorable.

"Why is there so much capital chasing commercial real estate? We have globalization and we are exporting jobs," he said. "This is a trend we are thinking about . . . and we don't hear a lot of discussion."

The trend toward pari passu notes, which involves splitting larger loans into several transactions, was also top of mind for investors. "Structural nuances are becoming harder to deal with," said Banc One Capital Corp. Senior Vice President Eric Hillenbrand. "With larger loans being split into three transactions, there is a different dynamic."

These transactions are inarguably less leveraged as a result, but the issue of control is in play, particularly if something should go wrong. "The call is for the investment-grade guys to understand all those nuances," Hillenbrand said. "Are the large loans crossing over? How many pools are they in? Is there somebody out there - not a special servicer - who has influence on a loan in your pool?"

Under no circumstances should investment-grade buyers assume that the B-note holders would be willing to cede control. "We're control freaks," Hillenbrand said.

Allstate's Moran questioned the ability of B-note holders to satisfy the needs of the investment-grade holders. "How do you plan on coordinating all this servicing with three or four different parties, each with their own vested interest, while keeping the investment-grade holders' interests in mind?" he said.

GE's Platt expressed concern over the astronomic legal fees that could result.

"You could have eight sets of lawyers that need to be notified of everything," she said.

The workout process has never been tested as no transactions containing pari passu notes have yet defaulted.

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