John B. Levy & Co. Weblog

April 1 (Bloomberg) — Royal Bank of Scotland Group Plc is selling bonds backed by commercial mortgages from several borrowers in the first sale of its kind since June 2008, gauging investor demand for the debt amid climbing defaults.

The $309.7 million offering, backed by 81 properties in states from New York to Missouri, includes $240.8 million in top-rated securities, according to people familiar with the sale who declined to be identified because terms are private. Of those properties, 78 are retail sites, the people said.

The new issue highlights a challenge facing Wall Street in reviving the $700 billion market as delinquencies rise and the value of mortgages fluctuates. Unlike other banks working on sales, U.K.-based RBS skirted the risk of holding the debt by not closing the loans as they were being pooled, the people said. RBS bankers have been arranging the deal for several months, they said.

“Nobody wants to sit with a huge book of business they haven’t sold,” said John Levy, president of Richmond, Virginia- based real estate investment banking firm John B. Levy & Co. “Accumulating this stuff for the long term is a problem. What if the music stops again?”

Bank of America Corp., JPMorgan Chase & Co., Deutsche Bank AG, Wells Fargo & Co. and Goldman Sachs Group Inc. are all approaching borrowers with terms for commercial mortgages to be packaged into securities and keeping the loans on their books until they’re sold, according to people familiar with the discussions.

Price Swings

That exposes the banks to risk because they need several months to assemble the mortgages from different borrowers, and it’s hard to guard against price swings on the debt in the interim, the people said.

In February of 2009, RBS said it would transfer 540 billion pounds ($820 billion) of toxic assets, including commercial property loans, into a new unit to be wound down or sold over three to five years. RBS CEO Stephen Hester said at a Jun. 16 conference that the bank would “never lend as much to real estate as we did, because we lent too much.”

The largest loan in the new offering is a $77.7 million mortgage on the 1,022,692-square-foot South Plains Mall in Lubbock, Texas, home to J.C. Penney and Dillard’s. A $72.6 million loan on Four New York Plaza in New York is the second largest. JPMorgan Chase & Co. occupies about 75 percent of the 22-story building.

CMBS Sales

Sales of commercial mortgage-backed securities plummeted to $11.2 billion in 2008 from a record $232.4 billion in 2007 as the credit market seized up, according to data compiled by Bloomberg. Even with U.S. government aid, only $3.04 billion of the bonds were sold last year, the data show. Those sales were backed by loans to a single borrower.

As of the end of February, late payments occurred on about 6.29 percent of commercial mortgages bundled and sold as bonds, more than five times the rate a year ago, according to Fitch Ratings. That figure may climb to 12 percent in 2012, the ratings service said.

Top-rated commercial mortgage-backed securities yield about 2.45 percentage points more than Treasuries, compared with 10.29 percentage points a year ago, according to a Barclays Plc index.

Investor demand for such debt has been strong, and other banks will be watching how the RBS deal sells to set the bar on where to price loans for future offerings, according to James Grady, a managing director at Deutsche Asset Management in New York.

“A data point on where investors are interested will help underwriters feel more confident,” Grady said.

Previous Issue

The last so-called multiborrower offering for commercial mortgage-backed bonds was a $1.09 billion sale in June 2008 from Bank of America that contained debt on 140 properties, according to a prospectus.

Michael Duvally, a spokesman at Goldman Sachs, couldn’t be reached for comment. Brian Marchiony at JPMorgan, John Gallagher at Deutsche Bank and Gabriel Boehmer at Wells Fargo didn’t immediately return phone calls seeking comment. Michael Geller, a spokesman at RBS, declined to comment, as did Kerrie McHugh at Bank of America.

To contact the reporter on this story: Sarah Mulholland in New York at smulholland3@bloomberg.net

An uncertain economy and jobs market continue to make it difficult for investors to deploy capital with conviction, but a new kind of normalcy is creeping its way into the market.

Normalcy is far from normal, but, like kids adjusting to the wacky new rules of a temporary parent in ABC’s “Wife Swap,” a degree of order is making the marketplace more active than it has been in almost two years.

In this environment, normalcy means spending time looking at distressed assets to purchase or negotiating with a lender to discount a loan.

These activities have taken the place of buying from a willing seller or negotiating with a lender to get acquisition financing. Nonetheless, certain patterns are emerging that make the market seem orderly.

Distressed assets are hitting the selling block from a variety of sources. In addition to the FDIC, which continues to sell portfolios of performing and nonperforming loans and real estate owned assets, several healthy banks are also marketing loan portfolios.

In a departure from the nuanced world of price discovery through passive “reverse inquiries,” Bank of America is marketing several loan portfolios directly to investors.

Marketing a loan for sale forces a bank to write the asset’s carrying value down to market. A more common strategy, known as reverse inquiry, allows a bank to leave the carrying value of a loan on the books without adjustment even if an offer comes in well below that level. Under a reverse inquiry, the bank’s role is passive versus active, which affects the accounting treatment.

According to a recent study by Commercial Mortgage Alert, banks wrote down less commercial real estate loan value in the fourth quarter than in the prior quarter.

Interestingly, Bank of America had the largest writedowns, which amounted to $837 million. Combined with the strategy to dispose of loan portfolios through direct investor sales, this is perhaps a sign that Bank of America is able to recognize and deal with its problem loans more aggressively than other large banks.

While it is too early to measure the overall impact, it could mean that things are loosening a bit in the distressed market.

Most industry participants believe the only way back to normal is through more liquidity in the capital markets and a return to a vibrant commercial mortgage backed securities (CMBS) market.

In fact, that was the government’s objective in February 2009 when it added CMBS to the TALF (term asset lending facility) program.

TALF provided bond investors a lending facility so they could leverage their capital and buy more securities. Approximately $12 billion in bonds were purchased under the program.

The idea was that a healthy market would eventually return and the government could stop its support, which is what happened March 31. The problem is that CMBS is not healthy yet, so the market is unsure of the program’s success.

In a promising signal for CMBS, however, RBS Greenwich (Royal Bank of Scotland) is coming to market this week with the first multi-borrower CMBS deal in several years. It is said to amount to less than $500 million and is made up of six borrowers with competitive loan pricing.

Although little capital is available for transitional properties or new development, loan pricing is good for stabilized properties that seek low-leverage loans.

Despite uncooperative U.S. Treasury yields, which are pushing pricing higher, five-and 10-year mortgages range from 5.75 percent to 6.50 percent, according to the John B. Levy & Company National Mortgage Survey.

Another example of the new normalcy is the sale of the 1.3 million-square-foot former Qimonda facility in eastern Henrico County to an affiliate of QTS out of Overland Park, Kan.

QTS manages data-center facilities throughout the country, and this facility could double the square footage in its portfolio.

Although the purchase price of $12 million is nowhere close to the former assessed value of $155 million, the facility now is in a position to become functional again. In this environment, functional is the new normal.