Phoenix — Column Financial, Inc., once one of the largest conduit lenders, is still doing a big business in apartment loans. The lender offers competitive rates and even interestonly financing, despite the crisis of confidence in the capital markets that has made it almost impossible to originate new conduit loans to sell as commercial mortgage-backed securities (CMBS). What’s Column’s secret?

“We shifted our entire staff to doing Fannie Mae and Freddie Mac loans,” said Vic Clark, managing director for Column, speaking at the APARTMENT FINANCE TODAY Conference in Phoenix in April.

Like most lenders, Column expects to originate almost no conduit loans in the first half of 2008. Experts predict that conduit lending won’t revive until 2009 at the earliest. That’s because the money that lenders used to make conduit loans came through structures that have broken and must be rebuilt one piece at a time.

The recovery can’t come too soon for borrowers who depended on high leverage and low interest rates from conduit loans. Conduits regularly offered loan packages that covered 95 percent of the value of a property, a standard that is much more difficult for other lenders to reach. The need for new high-leverage debt will become increasingly urgent as time passes and older high-leverage fiveyear loans begin to reach the end of their terms, according to the experts.

Interest rates have also widened since the conduit lending business collapsed because of the higher costs of capital and lower levels of competition to invest in apartment loans. Fannie Mae interest rate spreads have widened to between 220 and 225 basis points over Treasuries for 10- year loans, up from about 100 last year. Rates are even higher for other types of financing.

The price to compete

(10-year, AAA spread over swaps)
April 2008 289
March 335
February 276
January 125
December 2007 101
November 121
October 64

For lenders to once again offer competitive conduit loans, the interest rates they can offer will have to drop significantly. In early April, the lowest interest rate spread Column could offer on a 10-year conduit loan without losing money on the deal was 425 basis points over Treasuries.

Conduit interest rates are almost totally dependent on the yields demanded by CMBS investors. Since last summer, yields on 10-year, AAArated CMBS have gone from less than 100 basis points over swaps to more than 335 basis points in March, about the time of the Bear Stearns bailout/buyout, according to investment newsletter Commercial Mortgage Alert.

The “swap rate” is the fixed interest rate that the receiver in an interest- rate swap gets paid in exchange for the risk of having to pay a shortterm floating rate over the course of the swap’s term.

By early April, yields on AAA-rated CMBS had fallen back to 289 basis points over swaps. For conduit lenders to once again offer competitive interest rates, CMBS yield spreads would have to drop by another 100 basis points, experts said.

CMBS yields will also need to become less volatile before most lenders will be willing to offer conduit loans at competitive interest rates. “You’d want to see [spreads] settle in for at least a couple of weeks,” said Lisa Pendergast, managing director for RBS Greenwich Capital. “There is a significant risk to underwriting a loan in a volatile CMBS market.”

That’s because if lenders originate loans based on the latest CMBS yields but yields rise sharply before the loans can be pooled and sold, the lenders are left with money-losing deals.

Before panic hit the capital markets, it often took three months for a newly originated conduit loan to be pooled with other loans and sold, said Pendergast. When lenders begin to originate large numbers of new conduit loans, the securitization process for these loans will probably take four to five months. That’s because it will take longer to gather new loans into pools large enough to sell as CMBS: $1 billion is about the minimum size, said Pendergast.

The extra time will make conduit lenders even more vulnerable than usual to rising CMBS yields.

Another barrier to securitizing new CMBS is the backlog of bonds issued before the capital markets crisis that have yet to be sold to investors. Market participants estimate that the top investment banks have a total of $240 million in unsold bonds, of a variety of types, still on their books.

Investors are now unsure of the real worth of these bonds and worry that the relatively loose underwriting of the underlying loans could eventually lead to high defaults, despite the current low default rate on loans backed by CMBS, which remains at less than a third of a percent. That rate could rise as high as 1.5 percent and still be historically low, doing little damage to the yields of most CMBS investors, experts say.

In the first quarter of this year, firms issued $6 billion in new CMBS. That’s down from more than $60 billion the year before, according to Commercial Mortgage Alert, but still better than nothing.

Fannie Mae gains ground

In the meantime, until the conduit business recovers, lenders have been working overtime to fill the hole in the budgets of apartment developers with other types of financing. Fannie Mae lenders can now offer combinations of permanent and mezzanine financing that cover up to 95 percent of the value of a property for some types of loans.

In fact, Fannie Mae is still offering interest-only payment periods on some of its loans. “Interest-only is not dead at all,” said Meghan Varga, a director in Fannie Mae’s multifamily group.