The conduit lending business has a very faint pulse. Few new loans are being originated, and the flow of Wall Street money, the lifeblood of the conduit business, has slowed to a trickle.

But like the mythical phoenix rising from its ashes, the market for commercial mortgage-backed securities (CMBS) has slowly begun its resurrection.

Column Financial and Goldman Sachs, two major originators of multifamily conduit loans, have reopened their shops, trumpeting CMBS loan programs in the second quarter. The rates offered on those programs, however, are high, as are the credit standards.

“We’re coming back on the CMBS side, but nowhere near like we did in 2007,” said Kieran Quinn, president and CEO of Column Financial. “2007 was a bubble of unprecedented times, but now we’re back to the old days.”

Those “old” days were characterized by conservative spreads and underwriting, in contrast to the fullterm interest-only (IO) periods, low debt-service coverage ratios (DSCRs), and leverage routinely reaching above 80 percent that were common features at the CMBS market’s height.

Despite the return to historical norms, the CMBS market’s recovery might take some time. Moody’s Investors Service is forecasting only $35 billion in CMBS issuance this year, down almost $200 billion from the record $230 billion issued in 2007. Conduit originations for CMBS fell 96 percent in the first three months of the year compared to last year’s first quarter, according to the Mortgage Bankers Association’s quarterly survey. That was the lowest level of issuance since 2001.

“In retrospect, perhaps U.S. CMBS should be viewed as a $50 billion to $100 billion per year business that spiked to $200 billion during a credit bubble, rather than a $200 billion business having an off year,” said Nick Levidy, a managing director at Moody’s, in a report.

In today’s capital markets, where debt is increasingly harder to come by, a CMBS recovery would help restore the flow of capital to multifamily developers. To revive conduit lending, several things need to happen at the same time. Conduit lenders must be willing to originate new loans with strong underwriting. Wall Street investors must also be willing to buy those loans once the debt is packaged as CMBS. And investors must be willing to pay prices high enough to support competitive interest rates.

The lenders are willing

Conduit lenders began to emerge from the shadows in the second quarter.

UBS issued a term sheet for its commercial real estate conduit lending operation in May, the first time it was able to do so this year. KeyBank Real Estate Capital is exploring a new program to originate small-balance conduit loans and eventually bundle them into CMBS. And Wells Fargo continues to originate “conduit loansin- waiting,” or loans that it will hold on its books until the market recovers and they can be securitized.

“Clearly, people are starting to see the light at the end of the tunnel, and it’s not a train,” said Dan Smith, managing director at RBC Capital Markets. “People are now saying ‘when’ and not ‘if’ the market comes back, and that’s a very positive development.”

Like many conduit lenders, RBC hedged its bets when the CMBS market tanked, and began originating loans through Fannie Mae. The company originated about $2.5 billion in U.S. commercial mortgages for securitization from 2006 through 2007.

Now RBC is closely eyeing the market’s recovery and is poised to jump back in when it does. “We’ve kept our origination team intact, and we’re positioned to come back to the market,” said Smith. “I just need to see some more positive trends.”

Meanwhile, Column hopes to originate enough conduit loans to allow a CMBS issuance by the end of the year. The sooner that happens, the better, according to Quinn.

“I would love to get a deal done quickly so that people can see evidence of the market clearing of conventional, well-underwritten, 2008 underwriting standards,” said Quinn. “If we come to market with that, it will clear very quickly, spreads will come down, and we’ll start to rebuild the market.”

But the spreads are weak

The rates offered on the Column and Goldman Sachs programs, however, are more than 7 percent, uncompetitive with Fannie Mae, Freddie Mac, and life insurance companies. And the credit standards are much tighter than they were at the market’s height early last year.

“There are some lenders talking about quoting deals, but we haven’t seen sponsors ready to use it yet,” said Paul Brindley, a senior managing director at Holliday Fenoglio Fowler. “There’s such a big gap between a life insurance or bank deal at 6.25 percent, rather than a CMBS execution that’s 7 or 7.5. That gap’s got to narrow.”

Fannie Mae and Freddie Mac program lenders were quoting all-in interest rates that were even lower, around 6 percent for 10-year loans, in early June.

Industry watchers say conduit lenders must offer interest rates below 7 percent to remain competitive. At press time Column came close, offering 10-year loans with interest rate spreads of about 250 to 275 basis points over swap rates, for an all-in rate of around 7.25 percent to 7.5 percent.

Column’s underwriting standards have also gotten tougher since the capital crisis. IO loans, in which borrowers paid only the loan’s interest and none of the principal balance, were practically standard before the credit crisis hit. Column’s standard 10-year loans are now offered with full amortization over a 30-year schedule, with a balloon payment at year 10.

Column asks for DSCRs of 1.25x or higher, and the loans only cover up to 75 percent of a property’s value, compared to 80 percent before the crisis.

In contrast, Goldman Sachs began to offer five-year IO conduit loans in mid-May. The firm balances this aggressive IO feature with tightened loan-to-value (LTV) standards allowing it to lend only up to 70 percent of the value of a property. Like Column’s program, the rates are in the low- to mid-7 percent range.

“That’s really the first big salvo from the conduit side,” said Phil Melton, an executive vice president with Grandbridge Real Estate Capital. “Goldman’s five-year IO money is a great first step, and it’s the product that right now has the most appeal for developers.”

Conduit loans will likely see more interest initially from office, retail, and industrial borrowers that don’t have access to Fannie Mae or Freddie Mac. Column has confirmed that most of the interest in its program is coming from those other sectors, but the company is hoping multifamily loans will make up about 20 percent to 30 percent of its first new issuance.

Demand returns for CMBS, slowly

Although the interest rates offered by conduits won’t decline until the demand for CMBS improves further, the price investors are willing to pay for the bonds has already come a long way.

Yields for AAA-rated, super-senior CMBS, which decline as bond prices rise, were 140 basis points over swap rates in early June, according to RBS Greenwich Capital. That’s down from more than 300 in March, the worst month for CMBS so far. However, today’s yields are still multiples higher than before the credit crisis. For example, the bonds traded at a spread below 30 basis points throughout 2006.

The meltdown in the single-family market sparked the explosion in CMBS yields. Beginning in the spring of 2007, a string of hedge funds and high-yield investment vehicles suffered unsustainable losses from investments in subprime mortgages. In June, Bear Stearns Asset Management’s two high-yield hedge funds failed to meet their margin calls. In the following weeks, lenders seized most of the collateral and began to liquidate $3.8 billion in assets from one of the funds.

A glut of CMBS bonds hit the market. Prices collapsed for tranches of CMBS, like BBB-rated bonds, perceived as being more risky. Spreads rose from less than 100 basis points over swaps before the crisis to more than 1,550 in March, according to RBS Greenwich Capital.

CMBS issuers like Greenwich responded by delaying issuing bonds, and holding loans on their books instead. Other issuers resisted selling some tranches of CMBS, like BBBrated bonds, at deep discounts. The overhang of unsold bonds and the fear of spreading foreclosures made it difficult to value CMBS.

That made yields on AAA-rated CMBS more volatile, and they began swinging by as much as 100 basis points week to week. Lenders hate that kind of volatility. It’s difficult to set an interest rate for a loan without a clear idea of what investors might pay for the CMBS backed by that loan at issuance. Volatility pounded the CMBS markets despite low foreclosures in the underlying loans, as investors bet against the securities.

“The fundamentals on the marketplace are not being reflected in the volatility,” said Lee Cotton, past president of the Commercial Mortgage Securities Association (CMSA) and a vice president at Centerline. “If you’re betting against CMBS, you’ve probably made a mistake.”

CMBS defaults for multifamily loans were at just 0.35 percent through April, according to ratings agency Fitch Ratings, Ltd. Just 360 delinquencies have been recorded out of approximately 42,000 Fitchrated loans. That’s in stark contrast to the current 6.35 percent default rate of single-family mortgages.

Since March, the CMBS market has gradually improved. “We’ve seen enough progress in the market, and we know it’ll continue to progress,” Quinn said. “Spreads have come in enough, and we’ve convinced the market that they’re not going to see the wholesale defaults like in residential.”

The glut of unsold bonds also seems to have cleared, even for BBBrated bonds. “The last issuance that was done by Merrill a week or two ago sold out at all levels,” said Dottie Cunningham, CEO of the CMSA, in early June. “There is a demand for product from the investors.”

CMBS issuers have cleared their books of old conduit loans waiting to be issued. And forced sales of CMBS to meet margin calls are also over, according to CMBS traders. “The lists that we see now are sellers taking gains,” said Kent D. Born, CMSA president, “not forced sales.”

If the calm lasts, eventually traditional CMBS investors, like life companies and pension funds, will return to buy the bonds.

Altered market

When the conduit lending business comes back, it will look a little different.

Prudential, which originated about $3.6 billion in mortgages for the CMBS market last year, announced it will exit the market altogether. The company posted pretax losses of $107 million for its CMBS business in the first quarter.

“Our decision to exit was based on our conclusion that the business case simply did not prove out,” said Richard Carbone, Prudential’s chief financial officer, in a first-quarter conference call.

And when the market comes back, it will return with a higher degree of collaboration between competitors. The next wave of CMBS issuances will likely be smaller deals that feature loans originated from three or four partners. The days of originators putting $1 billion of loans on their balance sheets awaiting securitization are probably over.

“Since our competitors ultimately become our partners, we need to be able to work together,” said Smith. “There will be smaller deals, probably $1 billion to $1.5 billion, but they’ll have three or four partners.”

And new players are beginning to emerge. Freddie Mac is working to help matters along with a new conduit program—though it won’t be ready for prime time until the beginning of 2009.

Freddie Mac’s Capital Markets Execution (CME) program, currently in a pilot stage, is offering conduit loans with interest rates of just 6 percent, LTV ratios of up to 80 percent, and DSCRs that stretch down to 1.15x. The program also allows borrowers to take out supplemental financing after closing, providing unprecedented flexibility to conduit borrowers. (For more on the CME program, see page 30.)

Freddie Mac hopes to have an issuance or two done by the end of the year.

“There’s a lot of fear in the market right now. Our pilot will help provide confidence, and that will start to bring some stability back in the market,” said Mike May, Freddie Mac’s executive vice president of multifamily sourcing. “A couple of other issuers will get some deals off, and that success will breed success.”

No Conduit Bailout Needed

More conduit loans are going to get into trouble over the next year. Foreclosures will increase, and the rate at which conduit borrowers fall behind on their payments will soar by a factor of more than 60. That’s the analysis from Larry Duggins, executive managing director of Centerline Capital Group, who retired at the end of June.

He’s in a position to know: Centerline is a big investor in Bpiece commercial mortgage-backed securities (CMBS), putting it first in line to lose money from conduit foreclosures.

The next 12 months will put pressure on portfolios of conduit loans, said Duggins. He expects the scarcity of financing to push the price of apartment properties down and drive up capitalization rates—which express the net operating income of a property as a percentage of the sale price—by 75 to 100 basis points overall over the next 18 months.

As property owners lose their ability to sell their way out of trouble, the share of conduit loans in delinquency will rise from the current level of just 0.3 percent to near 2 percent, said Duggins. For perspective, the last time delinquencies reached 2 percent was in 2003, a year that went down in the record books as the biggest year ever for CMBS issuance, until 2004 broke that record.

“It’s something that the CMBS market could handle,” said Duggins. CMBS delinquencies are especially low considering that the foreclosure process for a commercial property can take six months to two years, meaning few of those loans in delinquency are likely to ever reach foreclosure, said Duggins.

Even so, Centerline has toughened its underwriting standards. As a B-piece CMBS buyer, Centerline has the ability to demand that issuers remove loans with weak underwriting from the pools of loans that back CMBS. That forces issuers to hold the weak loans on their own books.

Centerline can take that step because without a Bpiece buyer to stand first in line to take losses from defaults, no issuance of CMBS could go forward.

The power to kick loans out of CMBS pools makes B-piece investors the gatekeepers of conduit loan underwriting. Centerline now insists on conservative underwriting, fewer interest-only loans, lower leverage, and an end to risky underwriting of any kind in the loan pools that it invests in.

“The market is screaming for a more conservative approach, even though no one seems to have gotten burned over defaults,” said Charles Krawitz, senior vice president for KeyBank, a conduit lender. “Just because you got lucky doesn’t mean people are going to let you do it again.”

—Bendix Anderson