UPDATE 1-NYC commercial loan default likely, more seen-Lehman

(Adds bond index trading, other New York City properties)

By Al Yoon

NEW YORK, Aug 18 (Reuters) - An imminent default of a $225 million New York City apartment complex loan represents only the first commercial real estate mortgage featuring an aggressive type of underwriting that likely will go bad, Lehman Brothers said in a report.

The loan, for the Riverton Apartments high-rise in Harlem, was made assuming that the borrower would be able to convert 53 percent of rent-stabilized units to market prices two to three times higher by 2011, boosting cash flows, Lehman analysts said in the report dated Monday.

But the pace of conversion has been slow, leaving the current debt service coverage ratio at 0.28 times, compared with the 1.73 times under the assumed boost in rents.

So-called "pro forma" underwritings based on expected cash flow increases are present in at least $5.4 billion of loans in commercial mortgage-backed securities (CMBS), including more than $1 billion for the 2006 purchase of the Peter Cooper Village and Stuyvesant Town apartment complexes in New York.

Investors have shunned CMBS along with other credit-related securities this year amid concern that the slowing economy would exacerbate a rise in defaults from historically low levels. Similar to the faults in residential real estate, dealers seeking to ramp up issuance in 2006 and 2007 loosened requirements for loans that could be packaged into bonds, often allowing for expectations that prices or cash flows would rise, bolstering loan quality.

"We expect that additional pro forma loans will likely suffer a fate similar to Riverton Apartments," Lehman analysts wrote in the note confirmed by analyst Aaron Bryson.

"In addition to aggressive upside assumptions, weakening commercial real estate fundamentals will likely put further pressure on the borrower, increasing the value of the borrowers' 'default option' to walk away from a property with non-recourse, in our view," the analysts added.

Traders increased bearish bets on commercial mortgage securities, sending yield premiums on many "CMBX" derivative indexes to their highest since the peak of their stress in March. Yields on the junior "AAA"-rated portion of the CMBX4 index, which Lehman expects will take the bulk of losses on pro forma loans, rose 55 basis points on Monday to a bid/offer market of 615/630 basis points, according to a dealers.

Spreads on top-rated CMBX indexes have widened for five consecutive weeks amid concern that banks saddled with a glut of commercial loans on their balance sheets will keep trying to sell, and as general unrest in credit markets turns investors away from risk, analysts said.

Riverton Apartments loan sponsors Rockpoint Group LLC and Stellar Management "appear ready to exercise" their default option, Lehman said in the report. The loan, contributed to a CMBS issue by Deutsche Bank AG, will probably sustain a loss of 50 percent, it estimated.

The probable Riverton loan default is primarily a fault of aggressive underwriting rather than a comment on weaker real estate fundamentals, Lehman noted. Assumptions for increased cash flows for loans in CMBS also vary widely, it added.

Other New York City properties financed with the risky loans in CMBS include 666 Fifth Avenue, across from Rockefeller Center, and 110 East 42nd Street, across from Grand Central Terminal, according to the report.

Downgrades from major credit rating companies on CMBS containing the Riverton loan should be forthcoming, it said. (Reporting by Al Yoon; Editing by Jonathan Oatis)