Fed limits on US CMBS program may choke success

NEW YORK, July 7 (Reuters) - The Federal Reserve's program to boost U.S. commercial real estate lending may be tailored with such narrow specifications that its impact may fall far short of easing the sector's pain.

The Fed next week will launch a long-awaited lending program for investors that pledge to buy commercial property bonds that help finance office, retail and apartment buildings buffeted by the credit crunch. The two part program will offer loans against new and old commercial mortgage-backed securities in bid to draw investor demand and lower borrowing rates.

Lower financing costs are key to slowing the deterioration of credit for commercial loans that are heading into distress at a heady pace. Without easier credit, defaults will rise and prolong a viscious cycle of foreclosures and price declines.

But controversy has erupted over limits placed on investors asking for funding for purchases of existing bonds, whose rates help set new lending costs.

Disputed is a mandate for bonds to carry only stable AAA ratings, which is eliminating a huge chunk of the $700 billion market due to fresh downgrade threats by Standard & Poor's.

On Thursday, the Fed said bonds eligible for the Term Asset Backed Securities Loan Facility (TALF) must have trade dates of July 2 or later, further narrowing eligibility.

Calls among investors and analysts for the Fed to ease its criteria have so far gone unheeded.

"The ball is in the Fed's court to make CMBS TALF work," said Craig Lieberman, a managing director of commercial real estate at NewOak Capital LLC in New York. "It's an extremely important program to get right" to rescussitate the market, he said.

The rating requirement became a divisive issue after S&P, one of the four major raters of CMBS, in the face of puzzled industry opposition, adopted more conservative models that put many top rated bonds at risk of downgrade. Some 1,500 ratings were added to S&P's list of potential downgrades last week.

Unknown criteria, such as acceptable delinquency rates, has also increased uncertainty among investors as to eligibility of bonds they hold. If the Fed caps acceptable delinquency rates at 2.0 percent, for example, as few as 35 CMBS may be eligible, said Darrell Wheeler, head of securitized asset strategy at Citigroup Inc. in New York.

"The secondary market criteria was vague, and so investors remain uncertain on just what bonds the the Fed will accept for financing on the 16th," Wheeler said. "As a result the market has yet to see a broad tightening rally that is required to encourage new small and medium sized commercial loan originations.

A poor response to CMBS TALF would compare with success on the Fed's TALF for consumer borrowing sectors, which has lowered financing for financial companies making credit card, auto and student loans.

Lack of clarity on CMBS TALF's potential success is also holding back investors that have raised billions of dollars to spend on assets they expected to be in line for government support, said NewOak's Lieberman.

Risk premiums on top CMBS since mid-June have hovered in a narrow range near 700 basis points above a common interest rate benchmark. Yield spreads soared above 900 basis points as S&P first proposed its ratings models, but dropped back amid dealer demand for issues they were restructuring for investors.

Spreads may need to drop to 200 basis points to encourage lenders to resume new lending, NewOak's Lieberman said.

"We would expect that TALF-eligible bonds should tighten considerably versus non-eligible bonds, but this may not occur until after a successful auction," said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago.

"Expect those investors who get in on the first subscription to get in at the wides of the program," he said.