Ok, I admit that was weak. But in this market one has to lookfor humor wherever one can find it. I spent two of the past fourweeks in Manhattan talking to a variety of capital providers.Needless to say, the mood on Wall Street is gloomy at best.

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The new year began with a certain cautious optimism. Many marketplayers including myself had hoped that as the supply of new CMBSissuance dwindled, the supply/demand dynamic would reverse. Duringlate 2007, there were more bonds for sale than buyers. Given thefall off in CMBS production, we had hoped that at some point duringearly 2008, there would be more buyers than bonds.

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Unfortunately, this scenario has not played out. No new CMBSpools went to market during January, making it the first month in18 years without new issuance. In the absence of new securities,trades in the secondary market constitute the only actualtransactional volume.

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Senior AAA spreads began the year at Swaps + 88 bps. By earlyFebruary, spreads had reached the breathtaking range of 225 bpsover Swaps, well in excess of the all time high.

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Into this mess, Morgan Stanley and Bear Stearns stepped up andpriced a $1.2-billion TOP pool. But it did not help that WellsFargo pulled out of this TOP securitization citing unrealisticspreads in the market. Some had hoped that the TOP pool of newmortgages underwritten to more conservative standards would fairbetter than bonds trading in the secondary market. But insidershave told me that the quality of the mortgages fell somewhere inbetween the old and new underwriting standards.

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The market rallied briefly the week of Feb. 18 with Senior AAAspreads coming in about 25 bps. But that proved a false rally asspreads blew out again in late February and early March. It appearsthat some investors and issuers sold bonds to raise capital anddress their balance sheets for the end of the quarter.

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Spreads rallied somewhat later in the week when the Fedannounced that it would pump more liquidity into the market. Butthe Fed's actions, while welcome, did not address the core of theliquidity crisis. The rest of the week saw a cascade of bad newsstarting with a Carlyle Group bond fund defaulting on its creditlines and ending with the spectacular collapse of Bear Sterns overthe weekend of March 15.

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Misery loves company and CMBS is not alone as the rest of thecapital markets are in disarray. Spreads have widened across thecapital markets including asset-backed securities, corporate bondsand residential mortgages. Concern over the health of bond insurershas whipsawed the stock market while the muni fund market hasmelted down.

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All of this indicates that bond buyers remain on the sidelines.One investment banker told me that real estate in particular is nowa dirty word because of expectations that commercial real estatewill go the way of residential. Various analysts have estimatedthat commercial real estate values will drop 20% over the nearfuture. And indeed, cap rates have risen 50 bps on average sincethe meltdown began. At the same time transaction volume is off 69%from April of last year.

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Nevertheless, the current capital markets crisis began at a timewhen commercial real estate fundamentals were strong. The current.38% default rate for CMBS remains near an all-time low. Marketpundits expect CMBS defaults to rise over the near term as a weakereconomy hurts commercial fundamentals. The most pessimisticforecasts predict defaults will rise to between 1% to 2% over thenext year, in line with other historical down cycles. But thecurrent spreads for CMBS make sense only if default rates risecloser to 8%.

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It is hard for me to conceive of a scenario where defaults wouldreach a level four times the default rate of the early 1990snotwithstanding rising cap rates. The 1990s recession began withsignificant vacancy in virtually all product types throughout themajor US markets. During the go-go days of the 1980s, the marketwas awash in capital. Banks and equity sources continued to lendmoney for new construction in the face of double-digit vacancyrates. Once the downturn hit, lenders began experiencing losses asvacancy and default rates rose. Government regulators hit the panicbutton and made it difficult if not impossible for banks andS&Ls to lend.

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Today's situation feels very different. Commercial real estatefundamentals remain strong. Although expected to weaken with theeconomy, commercial real estate defaults should rise onlymoderately. Some remain concerned about the ability of propertyowners to refinance pending debt maturities. Indeed, propertiespurchased with high leverage over the past two years will suffer.But most fixed-rate CMBS loans originated over the past five to 10years have experienced both amortization and rising rents. As aconsequence, these properties are not overly leveraged and shouldqualify under today's more stringent underwriting. Furthermore,Libor has dropped from 5.7% to 3.1% over the past six months whichwill ease the pain for many floating rate borrowers.

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Ironically, the savior of today's capital market debacle islikely to be the capital markets themselves. The market has alwaysoperated on the basis of fear and greed. Wall Street traders tellme that investors agree that bonds look attractive today but thatno one wants to be the first one to jump into the market.

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Nevertheless, capital seeks a vacuum. Life companies and banksdo not have the balance sheets or appetite to fill the hole left bythe shutdown of the CMBS market. Yet there are signs thatsignificant liquidity is sitting on the sidelines waiting to takeadvantage of the ridiculously wide spreads. Rumor has it thatopportunity funds have raised upwards of $30 billion to purchasedebt securities while fixed-income shops such as PIMCO and TCW havestarted eying CMBS opportunities.

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I would guess that a few things have to happen before the marketrebounds. First, banks need to take further write downs to cleansetheir books. Second, we need a couple of quarters of continuedperformance to show the market that commercial real estate has notfallen off a cliff.

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The Fed's actions over the past few weeks provide a glimpse ofhope. The market had turned against Bear Sterns as customerswithdrew cash and fellow banks stopped lending to the company. TheFed arranged an emergency loan to the company through JP Morgan. BySunday, Bear was effectively bankrupt as evidenced by its agreementto sell itself to Morgan for the bargain price of $2 per share.Even then, JP Morgan only agreed to the purchase because of theFed's guaranties of certain Bear liabilities. Even more important,the Fed took the unprecedented action of providing liquidity toprimary dealers (consisting mostly of investment banks) byaccepting a wide range of mortgage collateral in exchange fortreasuries. The Fed has pledged $200 billion to this TermSecurities Lending Facility.

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The Monday following the Bear Sterns collapse was volatile, tosay the least. The Dow Jones Industrial Average sold off beforerecovering later in the day. But much of the recovery wasattributed to a rise in JP Morgan's stock price as the street feltthat the bank had bought Bear at a bargain price. But the widermarket, and financial stocks in particular, sold off. Moretroubling, rumors circulated that Lehman Brothers might fail. Atone point during the day, Lehman's stock had fallen 48%.

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On March 18, Lehman announced that it had earned 81 cents pershare for the first quarter versus analyst estimates of 72 cents.Goldman Sachs also reported better than estimated earnings shortlybefore the Fed cut the discount rate by another ¾%. The Dow Jonessoared by 420 points as it became clear that Lehman would notcollapse. Financial stocks in general rose 8% while Lehman rose46%.

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The Fed's actions indicate that it is willing to pull out thestops to address the current liquidity crisis. Lehman's andGoldman's earnings indicate that the large financial servicescompanies are unlikely to fail. Furthermore, Morgan Stanley andCitigroup have separately issued reports stating that fixed incomelooks cheap. Neither report was bullish, but the tone indicatesthat they are less bearish. It is too early to call a bottom butthis is the first indication of a possible change in attitude.

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In the meantime, deals are still getting done. CMBS may bemoribund for the moment, but life companies, commercial banks andcredit companies continue to close loans onto their balance sheets.Portfolio lenders have become more conservative in theirunderwriting standards but actively seek to put out debt. Havingsaid this, lenders have become selective.

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Finally, a few brave institutions have stepped up to buywhatever bonds come to market. I spoke to one experienced realestate lender that has been actively buying CMBS paper over thepast few months. He sees the current prices of bonds as a once in alifetime opportunity. He will happily hold the bonds in inventoryand suffer the mark to market because he knows that long term,spreads will tighten and the value of the bonds will rise. Hisbiggest fear is that the market will stabilize before he has usedup his liquidity. So who is right, the short sellers that knownothing about real estate or the long-time real estate lender thathas seen several cycles? I know whom I am betting on. ScottBottles is principal at George Smith Partners. The viewsexpressed in this article are the author's own.

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