Downward trend in rates can contribute to volatility

The news came as a bit of a shock to economists.

Jobs data released for February continued to show that, despite no change in the national unemployment rate, the economy is not adding jobs as quickly as projected.

Fearful of where yields could head, investors ran out and bought more U.S. Treasuries. That forced yields down.

This development combined with lenders' continued zeal for new deals prompted commercial mortgage rates to head downward during the past month. Rates now range from 4.25 percent to 5.25 percent for 5- and 10-year mortgages according to the Barron's/John B. Levy & Co. National Survey.

The dramatic decline in U.S. Treasury yields (about .25 to .30 percentage points over several days) has raised debate among real-estate debt wonks. They wonder what will happen if Fannie Mae and Freddie Mac have to adjust their portfolios to counter the prepayment risks associated with lower rates. This is technically known as "convexity-related hedging" and is blamed for the huge uptick in rates last summer when Treasury yields moved upward approximately 1.45 percentage points in two months.

According to August 2003 research by Robert Perli and Brian Sack of the Federal Reserve, periods of heightened prepayment risk (when rates fall quickly) lead to heightened volatility in the fixed-income market. This volatility feeds on itself and tends to amplify the downward trend. In short, when rates fall quickly, hedging activity tends to make rates fall even further.

In this falling interest-rate environment, lenders and loan originators have noted increased competition for new transactions. Additionally, institutions are reporting that their pipeline of already pending business is spotty - making each new loan opportunity increasingly important. The result for borrowers stepping into the mortgage market is that they may be surprised at what they find.

What is clear is that lenders are willing to relax their typical deal parameters to sign up new business. Two recent pools of commercial loans that were sold off as bonds depict a trend.

Several weeks ago Bank of America offered $1.3 billion in a pool of commercial loans where only 72 percent of the loans had escrows for real estate taxes and only 33 percent had escrows for insurance. Similarly, Bear Stearns' $1.1 billion offering had underlying commercial loans with only 67 percent having escrows for taxes and 59 percent having escrows for insurance.

Other anecdotal evidence of the relaxed lending atmosphere abounds. One example involves lenders that allow borrowers to pay interest only for a period of time - up to 10 years on lower leverage transactions - instead of amortizing the principal.

Another example involves lenders making loans where the underlying property is not "stabilized" (meaning that the occupancy rate has not reached market standards). These loans are structured with unfunded proceeds (holdbacks) that are released when the property stabilizes.

This aggressiveness is taking place in an economic environment that is still somewhat tenuous. Apartment properties continue to get low interest rates, and lenders make little differentiation between good and mediocre projects.

Sounding a note of caution, Torto Wheaton Research has concluded that there is a 97 percent chance that apartment values will decline by 4 percent by the end of 2006 and a 50 percent chance values will fall by about 12 percent during that time.

Of course, Torto Wheaton Research bases its conclusions on national trends, and each market has to be measured on its own. Job creation clearly plays into how healthy or unhealthy a market is.

According to the Bureau of Labor Statistics, Richmond added about 6,700 jobs from December 2002 to December 2003 and the unemployment rate fell to 3.5 percent. These are positive measures by any standard.

Andrew Little is an investment banker with John B. Levy & Co. He can be reached at alittle@jblevyco.com

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