If traders learned one major lesson from the market crises of 1998, it was that hedging asset-backed and mortgage-backed securities required hedging out spread risk - forcing players to pay special attention to the swap market, the ultimate harbinger of which direction spreads are going.

The reverberations of that lesson are still being felt today, especially in the commercial mortgage-backed sector -which is now 90% correlated to the swap market, particularly over the last year and a half - and the asset-backed market, which is only now beginning to adjust to this new pricing paradigm.

In light of the fact that the swap market determines the execution level of CMBS deals, sources say that CMBS market players are currently debating how they can shuffle the three major pricing and hedging factors - Treasurys, swaps and cost of funds - in order to make transactions less risky for lenders.

Already, it is rumored that CMBS lenders such as Column and First Union have quoted spreads using a new pricing paradigm that could mean better execution for lenders.

While players currently take the risks associated with swaps alongside the cost-of-funds risk, as well as the risk to overall profits, switching that swap risk to the other side of equation - alongside Treasurys, as it were - might create a new base rate that would take out a major component of risk for the lenders.

"This would create a much less risky situation," said Brien Wlock, a CMBS expert at J.P. Morgan & Co. "We would take a huge volatile component out of our risk side."

Now more than ever, swaps are extremely volatile. While they remained relatively flat two or three years ago, they seem to be bouncing back and forth now, creating a factor of volatility.

The problem with swaps is that there is a symbiotic relationship with CMBS, in that CMBS lenders will use the swap market to hedge their portfolio. But by using the swap market, more demand is created, and because there is more demand, the swap prices go up. When swap prices go up, there is less profit in any given deal.

For instance, if a spread is quoted at Treasurys plus 250, that number represents two components: swap costs and cost of funds/profits. Though the 250 remains constant, for every tick that the swaps go up, the profit goes down a tick. From a lender's perspective, linking that swap factor to Treasurys - instead of linking it to profits - would produce a remarkably advantageous scenario for a lender.

"My guess is that in the next 18 months this new method of pricing it will be a part of many deals," Wlock added.

This is especially true considering that many customers have complained that they are not happy with price guidance expressed in swap-adjusted terms.

"Lots of customers are running money against bogies that are not on the same basis as swaps," said Patrick Corcoran, the head of CMBS research at J.P. Morgan. "Then again, dealers in the Wall Street community find that the best way to hedge their profit margins on deals is with swaps, so it's not clear whether people are considering changing. Before swaps, there was no hedge for spread risks."

How Would Borrowers React?

Still, swaps are all over the map these days, and that might not be something that borrowers would be happy about. Therefore, at first blush the new "Treasurys + Swaps" paradigm might not sit well with them.

"It's going to be a tough sell," Wlock said. "If everyone did it, that would be the market. But it would be considered a confusing alternative, and more risky for the borrower. For the first guy that goes out there with this alternative, the reaction may be, Thanks, but no thanks.' Treasurys are fairly stable, whereas swaps jump all over the place."

"The only way to hedge your CMBS pipeline is to hedge it to the swap market," added Michael Hoeh, head portfolio manager at Dreyfus Corp. "Even if a dealer is hedging the CMBS pipeline with agency debentures or futures, it is going to be tick-for-tick with the swap market. A good portion of the risk will be mitigated by that."

Even for asset-backed securities, where spread risk is less of an issue, the swap market is becoming more widely used for pricings. For one thing, it is a shorter term market. Still, in the current Peco stranded-cost transaction, many of the eight- and nine-year securities are being priced off of the swap market.

Still, other market participants say that the new trend towards using swaps is simply a matter of changing the frame of reference to make a deal look better.

"The use of swaps migrated to CMBS as the universe of buyers expanded," said Stephen L'Heureux, head portfolio manager at AEW in Boston. "Rather than have spreads gapping out 60 basis points on a Libor basis they only now gap out a little bit on a swap basis. "I think some marketing creativity is going on there."

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