By Howard Esaki, principal, Morgan Stanley Dean Witter Inc.

A More Efficient Market

Last month, the summer IMN/Fabozzi conference in New York City attracted a record attendance of about 800.

Although attendance was up, the tone of the meetings was more muted than in the past, perhaps because many are realizing it is harder to do well in a maturing and more efficient market. The changes in the market are creating new challenges for issuers, investors, rating agencies, and even conference organizers.

For issuers, competition in loan originations is driving profit margins down. With interest rates rising, some panelists predicted excess capacity later this year. In addition, moving further out in time, the number of loans reaching maturity and eligible for refinancing will fall off because of the drought in new originations a decade earlier. We think there could be a round of consolidations among originators beginning as early as the second half of this year and continuing into 2000.

Challenges for Investors

While lower origination levels will be good for CMBS spreads, investors are having their own problems finding value. With the growth in the market, CMBS have attracted investors who are continually evaluating CMBS in relation to other markets. Unlike traditional buy and hold real estate investors, the new breed of CMBS investor will quickly enter and exit markets depending on perceptions of relative value.

In addition, since CMBS yields are now closely linked to other fixed-income markets, spreads move quickly in tandem with other sectors. This could lead to more volatility in short-run CMBS spreads, such as the violent widening we witnessed last fall. Even over the past two months, 10-year AAA CMBS spreads first tightened 17 bp and then widened more than 20 bp.

Rising levels of competition also affect rating agencies. Despite adamant denials at the conference rating-agency panel, it seems clear to me that credit support levels for loan pools of similar quality have fallen recently. I think this is driven by competition among the agencies for a market that is growing more slowly, and even shrinking this year. I strongly believe, however, that current investment-grade subordination levels for AAA CMBS are still too high. At the non-investment grade level, investors may want to start to more closely monitor subordination levels if the credit cycle turns.

The Search for Value

As noted earlier, the move toward more efficient CMBS markets will make the search for relative value in CMBS more difficult. At the same time, the creation of a widely available CMBS Index and its inclusion in the Lehman Aggregate makes it easier to hold money managers accountable for underperformance.

As is the case with other sectors, beating an index will be a formidable challenge for investors. To outperform the Index, investors will have to create mismatches in duration, credit, or liquidity. In any case, investors (and

researchers) are going to have to start digging deeper to justify something other than a pure index strategy.

Investors may take some solace that they are not alone in facing a tougher environment. Even conference organizers are affected by increased levels of competition. Next January, the Commercial Real Estate Secondary Market and Securitization Association (CSSA) has scheduled a winter conference in Miami.

IMN/Fabozzi will also hold a CMBS conference in January 2000 in Naples. Efficient markets sometimes make for tough choices.

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