On May 19th, the Federal Reserve announced that AAA-rated commercial mortgage-backed securities (CMBS) issued before January 1, 2009 would become eligible collateral for loans under the TALF. The Facility now offers advantageous credit terms to potential buyers of "legacy" or seasoned CMBS. The Fed originally created the program to provide liquidity to the consumer ABS and RMBS markets, but extended its eligibility to new-issue AAA-rated CMBS at the beginning of the month. Under the terms of the Facility, borrowers will be able to finance CMBS purchases with the option of 3- or 5-year non-recourse fixed-rate debt priced at the Libor swap rate + 100 bps, and a base collateral haircut of 15%. The Fed has announced that it will accept subscriptions for the new-issue CMBS program beginning in June; new subscriptions for the legacy CMBS program will begin in July.

While the expansion of the TALF program to include seasoned CMBS was highly anticipated and its potential effectiveness was debated, investors nonetheless reacted favorably as spreads on CMBS issues tightened following the Fed's announcement. Although the expansion of the program to include both new-issue and seasoned CMBS is not the only solution to the problems facing the commercial mortgage market, the Fed's actions are a step toward providing enhanced liquidity and re-starting commercial mortgage securitization—a step in the right direction. We have argued in previous articles that several measures are necessary to break commercial real estate's adverse feedback spiral, in which the lack of liquidity in the mortgage market creates a downward cycle of refinance defaults, weakened investor confidence, and the continuation of high mortgage spreads.

By expanding the program to CMBS, it is hoped that the pricing of whole loans that are financed through new CMBS issues will become more competitive with commercial lenders such as banks and life insurance companies, thereby increasing liquidity and providing a much-needed source of additional capital to refinance a growing pipeline of maturing commercial loans. In addition, the expansion of the program to include legacy CMBS will have additional beneficial effects. The program will help support higher pricing levels for new-issue CMBS, and it is also anticipated that capital-constrained banks and other financial institutions will see higher mark-to-market values on their AAA-rated CMBS, reducing the need for additional write-downs and losses. In turn, the need to conduct "fire-sales" of such assets will be greatly diminished, which will help break the cycle of higher commercial mortgage spreads and negative investor sentiment.

There are some positive signs that the securitization markets could eventually get back on track—reportedly, a few firms are developing 5-year loan programs to take advantage of the new-issue CMBS TALF financing—but there remain many unanswered questions, first and foremost being how future CMBS deals will be structured and priced. Rating agencies have revisited their models in recent months, resulting in a flurry of downgrades to subordinate CMBS bonds. Their actions suggest that higher levels of credit support will be required for AAA issues, but leave a degree of uncertainty as to how a new-issue rating agency model will evolve. Given the sharp decline in credit quality of CMBS issues, especially those of the 2006 and 2007 vintage, along with a general lack of liquidity in the marketplace, investors are likely to favor simpler deal structures, conservatively underwritten loans, and a better alignment of interests with the loan issuers. In addition, the TALF program does not provide financing for subordinate CMBS tranches. Who purchases the subordinate bonds or B-piece is particularly relevant to securitization's renewal: will traditional b-piece buyers, issuers, opportunity funds, or some combination of the above return and support the market? While issuers will have their pick of choice properties to refinance, the structuring, warehousing, and hedging of loans for securitization could be challenging in the current market environment of limited balance-sheet capacity and unsteady derivatives markets.

We believe that the resolution of many of these issues may take some time, and that a functioning securitization market helps alleviate the growing demand for refinancing. Clearly the need is increasing every month—according to the Mortgage Bankers Association, more than $350 billion of CMBS, bank, agency, and life company commercial and multifamily loans come due between 2009 and 2010, while existing sources have the capacity to refinance only a fraction of this amount. As the new securitization model evolves, we are likely to see different structures emerge and be tested in the marketplace. It is more likely that we see some smaller single-borrower or large loan deals enter the marketplace first, followed by a gradual acceptance of larger multi-borrower deals.

While some investors today may be skeptical of new CMBS emerging, due to many of the inherent risks and collateral issues in seasoned CMBS deals, we believe that new CMBS, along with investments in whole loan originations, may offer compelling opportunities for investors. New loan structures and underwriting have become very conservative in the current market environment, as spreads and cap rates are currently being quoted at wide levels. In financing high-quality, stabilized properties, originators have ample choice. In the past, loans that were originated during or just past a period of real estate recession tended to have much better credit performance than those originated at other points in the cycle. The combination of these factors, combined with a "re-setting" of more favorable credit enhancement structures in CMBS, could offer investors very favorable risk-adjusted returns.