Is the beast starting to stir again?

Three years after derivatives based on the payments of interest and principal of residential real estate loans caused heavy losses for some investors, a market for similar derivatives based on commercial real estate is emerging.

Investor demand is reviving the market for this exotic type of mortgage- backed securities, which was moribund after the bad publicity surrounding them in 1994.

The $2.6 billion of issuance in the first quarter was more than half the volume for all of last year. Volume for the entire mortgage-backed market was $415 billion in 1993 but collapsed to one-tenth that in 1995 before starting to recover in the second half of 1996.

Traders insist investors in these securities are more sophisticated today than the county treasurers and public pension fund managers who were sold the instruments in the early 1990s.

But James X. Callahan, executive director at the Pentalpha Group, a Greenwich, Conn., consultancy, warns that the revival of strips, as the securities are known, may be paving the way for the next round of heavy losses.

"These securities are more sensitive to default than ever before," said Mr. Callahan, formerly a managing director and senior trader at Prudential Securities.

They are riskier, Mr. Callahan says, because lenders are making loans to shakier credits than before. Traders are including these troubled loans in the securities to keep up with buyer demand for high-yield investments.

Derivatives are contracts whose value is based on the value of some other asset or index, such as stocks, interest rates, or foreign exchange rates.

And derivatives based on the performance of real estate loans are perhaps the most speculative. Interest in these exotic contracts shrank drastically after Orange County, Calif., which bought many of them, filed for bankruptcy in December 1994.

But the market started to crank up again last summer, said Ranjit Kripalani, head of the mortgaged-backed group at Chase Manhattan Corp.'s securities unit.

Investors are buying the securities because yields for most plain- vanilla bonds and asset-backed securities have tightened considerably and "there's an insatiable demand for spread out there," Mr. Kripalani said.

Individual mortgage-backed deals are generally bigger than they were in the 1980s, he said, but they are less complex. And investors-mainly hedge funds and real estate investment trusts-are more sophisticated than those that burned, he said.

"No way are municipalities buying these things," he said. "Compliance offices all over Wall Street are keeping an eye on that."

Municipalities, school districts, and pension funds got into trouble in 1994 by leveraging public money to invest in the securities.

Commercial real estate loans are getting packaged into securities more often nowadays because more of the loans are available, say traders. They estimate that approximately 60% of residential mortgages that could be securitized have been. But only 15% of multifamily and commercial properties have been securitized.

Risks associated with commercial mortgages are very different from those associated with residential mortgages, traders note. Commercial mortgages run into problems when credit problems worsen and obligors default. Owners of residential mortgages risk losses when homeowners pay off their mortgages early.

What worries Mr. Callahan is the lowering of credit standards for commercial mortgages to be packaged in securities.

"Six months ago it was rare to go below a triple-B credit in preparing a mortgage-backed bond," said Mr. Callahan. "Unlike earlier deals, newer transactions are being influenced by non-investment-grade classes in them."

Mr. Kripalani counters that no one playing the game now is unfamiliar with the derivatives' potential for losses. Today's derivatives investors "understand real estate and understand credit," he said.

He adds that mortgage-backed securities have fewer tranches than those sold in the early '90s, meaning the chance for a piece winding up in inappropriate hands may be less.

Charles W. Smithson, managing director at CIBC Wood Gundy, agrees that safeguards are better than when real estate-related derivatives caused their last mess.

"The dynamic of how they are sold has changed," he said. "A trader now will want the buyer to sign off, plus the buyer's boss, and the boss's boss."

But with an instrument as explosive as these kinds of derivatives, Mr. Smithson acknowledged that there are bound to be casualties.

"Will someone somewhere lose money?" he said. "Absolutely. These things are too volatile for that not to happen."

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