At least five companies are said to be scrambling to set up the first commercial mortgage conduit program in Europe, while debate continues over whether such a program will find a receptive audience on the Eastern side of the Atlantic.
Morgan Stanley Dean Witter, J.P. Morgan, Lehman Brothers, Merrill Lynch & Co. and Donaldson, Lufkin & Jenrette are among the firms that Street sources said are now in the process of examining and assembling programs that will purchase commercial mortgages in bulk and regularly securitize them.
"We're exploring it, others are exploring the potential, but there's no certainty that it's going to happen," said Mark Landau, a managing director at Merrill Lynch.
Morgan Stanley seems to be the furthest along in its plans, as sources said that the company will have its first conduit deal ready by late summer or early fall. Morgan Stanley could not be reached for comment by press time.
To date, European commercial mortgage-backed securities deals have mainly been single-borrower transactions or re-securitizations of seasoned paper, a trend that's contributed to the market's modest growth pace in the last few years. Creating a conduit, which has become the standard method of issuing CMBS in the U.S. in the last decade, could jump-start the European market and bring it up to par with the States.
That's the theory. In practice, the potential for conduits to revolutionize Europe is very much in doubt. As bankers delve further into the European commercial mortgage market, they are discovering a chutes-and-ladders game of non-standardized mortgage pools, an still-anemic investor base, a preference for floating-rate bonds (which don't fit well in conduits) and much more competition from traditional lenders.
"There's a scramble to establish business overseas but those markets are much less vibrant than those in the United States," said Michael Youngblood, head of mortgage research for Banc of America Securities. "The construction process is much longer and the permitting process is much more difficult."
The key argument observers make against the growth of a conduit market in Europe is that the market conditions which spawned the U.S. network in the early 1990s have not emerged on the Continent or in the U.K. The U.S. conduit market began in the aftermath of the real estate market's collapse in the late 1980s, when traditional bank lenders fled the industry and left borrowers behind. With no competition, conduit programs were able to have their pick of the field and build their businesses at a leisurely pace.
By contrast, "these efforts [in Europe] are purely opportunistic. They are not dealing with captive markets, nor dealing with any market dislocation, nor the reluctance of any traditional lenders to lend," one head of CMBS research said. "Europe did not experience the huge dislocation in real estate like we did that gave conduits an opening."
Merrill's Landau acknowledged that building an audience for conduits is going to require some toil. "Conduits have to compete on terms, rates, lack of guarantees," he said. "There is real competition in Europe whereas in the States conduits grew up due to a lack of competition." Among some of the keenest potential rivals for conduits are well-entrenched European lenders like ABN Amro Bank, which have built long-term relationships with many commercial mortgage borrowers.
Another area of debate is how much growth potential is left for the commercial mortgage market in Europe. "Europe is essentially fully built, and there are very low rates of growth in these economies. You're dealing with populations that are in decline and zoning laws that would make California look like a cakewalk by comparison," Youngblood said. "You can't just think the conduits are going to show up and make a ton of money."
Asia seems a more appropriate venue for a conduit market. Countries like Japan have experienced a real estate downturn that is almost a clone of the U.S. market's earlier travails, and the growth of new commercial real estate is exploding. For example, take the current competition between Shanghai and Taipei to house the world's largest building. "If there is a good opportunity it will be in areas like Japan or Asia where circumstances not dissimilar to what we had in the early 1990s," one source said.
Other problems are also apparent for the European effort. The lack of standardization in commercial loan origination will make a conduit based in France, for example, have a hard time assembling loans from other European Community nations like Spain and Germany, one source argued.
"The lack of standardization is material," said James Callahan, executive director of the Pentalpha Group, a commercial real estate advisory firm. "Until that's dealt with there will be a lot of talk but not a whole lot of volume. I don't see conduit growth on a consistent basis."
CMBS that do thrive in Europe will likely be short-term, bank-related paper, most likely offered on a floating-rate basis, he added.
For conduits, floating-rate mortgages present a new puzzle, as constructing securitizations of such paper will mean the creation of such structural necessities as an interest-only strip, for example.
Players involved in setting up conduits, however, remain hopeful that changes in the market will provide a foothold for new programs. Bankers based in the U.K. noted that they have seen a change in attitude among debt providers toward securitizing greater portions of their mortgage holdings.
"There are things that don't fall neatly into the commercial mortgage box, so there's a lot of forces at work that will push toward us seeing a more active securitization market," said Merrill's Landau.
Education of the investor base on the benefits of conduits, however, is not going to be a problem for U.S. players, one banker noted. "Wall Street doesn't mind taking long distance flights. They would love to sell this stuff over there," he said.
- Christopher O'Leary