Though CMBS cumulative default rates have doubled (rising from 1.02% in 2001 from 0.54% in 1999 for Fitch-rated transactions), experts say that it's not as bad as it looks.

And though the rise in default rates is significant, 1.02% is still way below industry averages. According to Standard and Poor's, the average commercial mortgage delinquency average for the entire history of the American Council of Life Insurance (ACLI) data series is 2.3%.

"Although we've seen a significant increase in cumulative default rates, they are still much lower than the default rates we have seen in the early 90s," said Diane Lans, senior director at Fitch, at a conference call held last week. "This is just a continuation of the real estate cycle."

She added that the real estate market has been existing in a Utopian-type situation in recent years, and that Fitch never expected the low level of defaults seen in recent experience to continue.

Though the increase in defaults was expected and the numbers are not as bad as they seem, market participants are anticipating the worst and are pricing their bonds accordingly.

"Usually the CMBS delinquency rate rises .25 % every year, because the CMBS loans are only a few years old and the delinquencies increase with loan age," said Darrell Wheeler, CMBS strategist at Salomon Smith Barney. "While we had predicted a significant increase in the delinquency rate in 2001, most participants were surprised to see one year's increase in one quarter. The delinquency figures improved somewhat in April." (see table below)

However, in anticipation of increased delinquencies, the market has been pricing premium bonds as though they incur a 2 or 3 % annual default rate, which translates to more than 20 % of a mortgage pool defaulting over a ten-year period.

"We feel a 14 to 18 % pool default target is more realistic and in February published a suggested Salomon default vector for investors which weights the majority of the defaults in the near term to account for possible immediate economic recession," Wheeler said. "Since February, the default assumptions have improved somewhat, but we still expect investors will want to see demonstrated collateral performance before they tighten their assumptions to reflect reality. Thus the current premium bond remains cheap."

Credit is what counts

"The increase in delinquencies is part of the normal aging process of loans," said Michael Youngblood, head of real estate research at Banc of America. "Our largest issuance years were 1998, 1999 and 2000. It should not surprise anyone that we shall see an increase in delinquencies. What matters is whether we are seeing a decrease in credit performance."

Which we are not: despite the defaults, the ratio of S&P upgrades to downgrades, for instance, is still in favor of the former. So far this year, S&P upgraded 47 CMBS classes and downgraded 15. The same trend was seen in 2000, when the rating agency upgraded 88 CMBS classes and downgraded 22.

Further, a lot of these downgrades were driven by the lowering of the rating on CTL deals caused by corporate downgrades, which does not really reflect on the performance of the actual properties. The rest of the downgraded loans were in the lodging and healthcare sectors, which are traditionally considered weak anyhow.

"A corporate downgrade does not mean that the real-estate is non-performing," said BofA's Youngblood.

A prime example would be the case of Rite Aid, where despite the corporate downgrade, the company was able to make payments on CMBS properties.

And there are still some anticipated upgrades in the horizon.

"We are still waiting for year-end 2000 figures to see what the upgrade potential is for a fair amount of deals that had subordination increases," said Roy Chun, a director from S&P, in a conference call last week. However, "We do expect that we'll see more downgrades but primarily in the non-investment-grade area. At this point, we don't really have any investment-grade ratings that are at risk of being possibly downgraded."

Painting a bleak picture

S&P predicts that mortgage delinquency rates will likely expand across all property types. In 2000 the onus was on the lodging and healthcare sectors, which S&P thinks will still suffer the most in 2001.

The rating agency said that based on the current baseline economic forecast, the average delinquency rate could reach up to 1.5% to 2.0% in early 2002 and might even go up to the 2.0% to 2.5% range by the end of next year.

"If we really have a 1990-1991-like recession, that will have dire consequences for the economy and potentially the real estate markets," said S&P's Peter Kozel, a director.

Fitch follow-up report

Though not as bad as S&P, Fitch has also indicated that CMBS will be seeing a less-than-perfect scenario.

"Fitch believes we have moved from what was considered a favorable B' stress real estate environment that could not be sustained over the long term to a more stressful BB' environment," said Fitch's Lans in a recent report.

In the press conference, Lans announced that a follow-up study will be released soon focusing on whether the losses on these defaults exceed expectations. One area touched on in the upcoming report is the differentiations between monetary defaults and non-monetary defaults.

A non-monetary default involves the non-compliance with a requirement in the payment of a loan, usually a mere procedural matter. This type of non-compliance, however, does not allow a servicer to accelerate payment on a note or to foreclose on a borrower.

"A non-monetary default is not a real economic event," said Youngblood. It's the monetary default that counts because "ultimately the loan's performance depends on whether monthly payments are made or not."

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