Just when it seemed the post-recession CMBS market was beginning to hit a rising stride, the industry slammed into a roadblock instead. During the second quarter, conduit lenders were pricing spreads of about 200 basis points (bps) over the benchmark 10-year Treasury swap, making them competitive with Fannie Mae and Freddie Mac for the first time in at least three years. New conduit lenders—and old players such as Prudential and PNC that had shelved their operations during the downturn—seemed to open up shop every week.

But this brief, if brilliant, candle snuffed out during the summer months. Driven by capital markets volatility, including the European debt crisis and the debt ceiling drama, spreads widened out by at least 100 bps on 10-year loans in July, issuing a heavy blow to the conduit market. Then in late July, ratings agency Standard & Poor's (S&P) withdrew its rating on a $1.5 billion CMBS offering from Goldman Sachs and Citigroup, forcing the entire deal to be dropped at the 11th hour. S&P then did the same with a $1.19 billion Freddie Mac CME issuance.

S&P found a flaw in its review process relating to its calculation of debt service coverage ratios (DSCRs), causing it to abruptly pull its ratings. This development sent shock waves throughout the investment and securitized lending communities, placing more hurdles along the beleaguered sector's path to recovery.

S&P resumed rating CMBS issuances nine days later, but by then, the damage was done— an already volatile market grew even more jittery. “Such an event is unprecedented within the CMBS market,” said Richard Parkus, head of commercial real estate debt strategy at New York–based Morgan Stanley Research, in a statement. “The manner in which S&P took its action has severely eroded investor and issuer confidence in its ratings."

What this all means is that the CMBS sector is, by most measures, back to square one. And to regain the ground it lost so suddenly— while also continuing to work back to its pre-recession volume—will require a few dynamics to fall into place. A stable or more robust economic recovery driven by job growth would certainly inspire investor confidence, as would a more favorable perception of the credibility of ratings agencies such as S&P. But in many ways, the CMBS market is sputtering because it doesn't know what tomorrow will bring—thanks to new and looming regulation, the industry will soon have a whole new set of rules that may fundamentally alter the mechanics of securitization.

Detours and Delays

For many, these developments are just a detour on a longer road to recovery. So far this year, the CMBS market had been improving considerably from 2010, when just $11.5 billion in commercial-mortgage bonds were sold; to date in 2011, more than $20 billion worth have been sold. “While this is a pause, the market in general is still headed in the right direction," says Mike Flood, vice president of legislative and regulatory affairs for the New York–based trade group the Commercial Real Estate Finance Council. “While everybody's a little gunshy after the last two years, we're still ahead of last year and projected for $30 billion this year."

That growth is being driven in part by increased investor appetites, which further spurs more lenders to enter the space. In fact, the number of conduit lenders has jumped from a handful in the first half of 2010 to more than 30 today. Consider also that in July, Prudential Mortgage Capital re-entered the conduit space, striking a joint venture with Perella Weinberg Partners to originate CMBS loans. Once a heavyweight in the space, closing between $2 billion and $3 billion annually, Prudential discontinued conduit operations in 2008. In the past year, Citibank, KeyBank, and Berkadia are just some of the conduits that have joined titans like Wells Fargo, Deutsche Bank, and Morgan Stanley in the market.

“The GSEs and life companies right now have a pricing advantage over the CMBS market because the cost of capital is lower. But that won't always be the case,” says David Twardock, president of Newark, N.J.–based Prudential. “Different capital sources will be more competitive at different points of time."

Prudential, which also offers agency executions and portfolio loans, sees the CMBS program as an important complement. For instance, CMBS will often offer better terms than Fannie Mae—lower DSCR, higher leverage— in Fannie's pre-review markets. And the conduit sector isn't afraid to go into tertiary markets, as opposed to a life company book, which often focuses on the major metros.

“It's the breadth of the market that the conduit will serve that differentiates it, and then the speed with which the deal can get executed,” Twardock says. “We'll absolutely go to secondary markets. And a really well-run multifamily property in a tertiary market without a lot of supply issues would be a terrific asset for the conduit."

2.0 or 1.1?

Many have dubbed this latest iteration of the sector “CMBS 2.0,” to signify its reincarnation. And indeed, the loans made thus far have been at lower leverage levels and higher DSCRs than the insane underwriting that characterized the last boom period.

“The underwriting for a CMBS transaction today is every bit as rigorous as a Fannie or Freddie loan,” says Vic Clark, a senior vice president focused on CMBS production for Bethesda, Md.–based Walker & Dunlop. “It's almost identical, and that's the way it should be."

But others question the “2.0” label, asking if the industry has really changed all that much. Isn't today's conservative CMBS underwriting more a function of a wobbly industry still trying to find its legs, and less an indication of a permanent shift? “I'm hopeful CMBS can be reinvented,” says Doug Bibby, president of the National Multi Housing Council. “But to me, it's CMBS 1.1, not 2.0. And nobody has really fundamentally disagreed with me on that."

The CMBS industry will soon have a new set of rules via the Dodd-Frank regulatory reform bill, which may transform the way the market operates, and make it more fitting of a 2.0 label. Some of the potential changes to the CMBS industry that may arise from those new regulations include a 5 percent risk-retention requirement that will be fulfilled either through the securitizer or the third-party B-piece buyer. Another requirement of the proposed reforms is that the originator/issuer would have to take its profits over time, rather than earning them up front.

One reason Prudential favored a joint-venture arrangement for its re-emergence in the space is that it wouldn't have to create a new internal CMBS warehouse—the place on the balance sheet where loans reside pre-securitization. Instead, the joint venture has created its own warehouse. And that warehouse was designed to be flexible, given the moving target of regulatory reform. “This venture will have the flexibility to hold positions in accordance with risk-retention requirements,” Twardock says. “And it's set up so that if it needs to, it can earn its profits over time."

The wave of rule making yet to visit the CMBS industry will likely cause the execution to become a little more costly, which may further hamper the sector's recovery. “When you add regulation and checks and balances, there will be a natural increase in costs,” Flood says. “We believe that increase will be for everyone, from the issuer to the borrower, and how that shakes out all depends on the final regulation."

Indeed, everyone in the industry—originators, issuers, investors, ratings agencies—is still trying to figure out where things are, and where they're heading. In some ways, conduits, investors, and ratings agencies are in a sort of standoff, each with its own dueling agenda. Investors want stronger oversight; ratings agencies want their credibility back; and conduit lenders want clarity—but not at all costs. Each of those parties played a role in the industry's demise by taking their eyes off the ball in the last boom period. Yet at the end of the day, conduits don't want the 5 percent risk-retention requirement, nor do they want to take their profits over time rather than up front. So, like Fannie and Freddie, conduits would like to minimize any potential disruption to their business, even though they know they have to be slapped by the invisible hand of government to step confidently into the future.