Leading with the good news, the commercial mortgage finance market is back and growing at a brisk pace.  From a few standalones in the fourth quarter of 2009, we’ve gotten to a remarkable place.  Even during the first half of 2010, while lenders were hesitantly starting to lend, precious few lenders actually had real balance sheet availability for securitization.  That changed.  We’re back!  

Almost as soon as these markets began to function again, complaints about the quality of the loans began to bubble up.  OK, LTVs remain modest and, broadly, we’re not  underwriting pro forma income, but structural rigor and simplicity did not long endure.  Give me a break.  The joke has always been that our business had a seven year cycle and five year memories so that once in every cycle we’d recapitulate the errors of the last.  But five months?

Certainly a sort of Gresham’s Law is at work here: aggressive underwriting drives out conservative underwriting.  There’s a shocker.  But the pace of change has caught most market participants, and certainly me, by surprise.  I thought we’d muddle along with relatively low LTV structures on essentially problem-free real estate assets for the better part of a year before starting to see what we’re already seeing.

On reflection, however, what’s happened shouldn’t be a surprise.  The genie does not go back into the bottle.  Technology does not get unlearned (Dark Ages aside arguendo).  We’ve developed sophisticated financial engineering, a set of structures and documentation to work around innumerable issues presented by “challenged” properties.  That technology is not going away.

So the originator agreed to alter the spread based on subsequent performance?  No problem!!  One, prepare an A/B.  Two, shove the variability into the retained B.  Three, size and price accordingly.  So the borrower needs to take a property out of a multi property loan?  Voila!  Bake in a substitution mechanic (and more easily now given REMIC reform).

Moreover, we need lots of mezz and we need B notes.  That just is.  The rigor of LTV, combined with a still very benign interest rate environment means that LTV caps mortgage loan size, leaving plenty of revenue to service a high yield coupon.  Welcome mezz and B Notes to close the gap between CMBS 2.0 (or is that more like 1.01?) and the borrowers’ hunger for proceeds.

Loan performance is measured through the dual metrics of the incidence of default and the severity of loss.  Complexity and structure tend to go to the severity.  As long as LTVs remain modest and underwriting remains anchored to in-place cash flows, who really cares about pesky structural complexity?  The loan won’t go bad, right?  Ya just gotta believe to play.  Let’s face it, complexity is fun.

By Rick Jones.