As the CMBS market begins to see a pickup in the new-issue pipeline, the increased competition among conduit originators has led to some erosion in underwriting quality.

Market players say that this "opening of credit" should be seen as more of a normalizing of the CMBS market, and not merely as a deterioration of market standards.

The more conservative lending seen in 2010 as well as the lowered overall leverage in CMBS yielded significantly higher-quality collateral. However, JPMorgan Securities analysts said that the pace of new issuance this year has lead to greater average haircuts to underwritten net cash flows and a slightly larger differential between stressed and underwritten LTVs.

The market was kick-started last month by Deutsche Bank and UBS (DBUBS 2011-LC1) coming to market with a $2.2 billion CMBS transaction. The deal's $1.1 billion triple-A-rated, 4.62-year tranche priced at 115 basis points over swaps to yield 3.51%. Meanwhile, its $459 million, triple-A-rated, 9.7-year portion sold at 120 basis points over swaps to yield 4.91%, with parts of the deal reportedly three times oversubscribed.

That offering was quickly followed by a succession of deals that also priced. Among the list is the Morgan Stanley and Bank of America Merrill Lynch (MSC 2011-C1) offering, which also priced its $597.15 million, triple-A tranche at 115 basis points over swaps, to yield 3.65%.

According to market reports, Royal Bank of Scotland and Wells Fargo's (WFRBS 2011- C2 ) $1.3 billion CMBS, priced their transaction's triple-A, A4 tranche tighter than the first two deals at 100 basis points over swaps. The shorter-dated triple-A tranches priced at 115 basis points over swaps and 120 basis points over swaps.

Unlike 2010 single-asset deals, these 2011 vintages have also included B-note tranches and many other features that characterized transactions underwritten before the financial crisis.

The collateral includes IO loans, mortgages on properties with mezzanine financing in place (or provisions allowing the borrowers to get such financing) and reserve accounts that are not fully funded when the deals close.

The first transaction to price this year from Deutsche Bank and UBS had a stated LTV ratio of 62.3% - a relatively mild increase from the sub-60% levels of last year's deals.

However, after taking into account other forms of leverage baked into the deal, Fitch Ratings put the "stressed" LTV ratio at 91.9% in a presale report on the deal. The average stressed ratio for fixed-rate transactions Fitch rated last year was 82.7%.

Five of the deal's loans, representing 18.2% of the pool of collateral, pay only interest for the first five years before they begin paying down principal. Two other loans, representing 1.6% of the pool, do not pay any interest until they mature.

Some of the properties securing the loans are being used as collateral for additional debt. Two loans, representing 7% of the pool, have additional mezzanine financing, and five loans, representing 7.3% of the pool, have additional subordinate debt. Three others, representing 25.7% of the pool, allow mezzanine financing to be obtained in the future.

The Morgan Stanley and BofA Merrill deal has a Fitch-stressed LTV ratio of 92.6%. None of the loans in the collateral pool are interest-only until maturity, but four, representing 31% of the pool, pay only interest for an initial period.

Additionally, one loan, representing 11.6% of the pool, has additional mezzanine financing in place, and another loan, representing 3.5% of the pool, has additional pari passu debt (which would have equal rights in collection). Six other loans, representing 14.7% of the pool, allow mezzanine financing to be obtained in the future.

Not only have these lower-quality assets found buyers, but the demand for them has driven pricing in.

According to data from Barclays Capital, the triple-B-minus tranche on the Morgan Stanley and BofA Merrill deal priced at 205 basis points over swaps - tighter than the prior deals this year and the initial price talk. Barclays analysts said that the spreads coming in at the triple-B-minus level reflect "increasing market optimism and investors' interest in relatively low leverage."

 

Demand Greater than Supply

Scott Buchta, head of investment strategy at Braver Stern Securities, said that the looser credit quality in these newer loans is a function of the pendulum swinging back toward the middle for the CMBS market.

"The CMBS market has had more of a head start than the residential space in that it had [the Term ABS Loan Facility or TALF] to help tighten spreads in the secondary market, and that has lead toward pricing becoming more economically feasible in origination of new loans," he said. "That is coupled with a growing demand for new securitization paper when all other sectors have had very limited supply."

In other words, the CMBS sector has had to widen the credit window to grow origination levels, which entails more leverage in 2011 vintages. However, the widening of credit has created more liquidity on the CMBS side and that, according to JPMorgan analysts, means that many of the legacy loans may be able to refinance more easily than many investors feared.

Buchta added that the demand is such that CMBS structures can now include loans that originators could not have dreamed of getting done a year ago when underwriting standards were much tighter.

According to JPMorgan analysts, 20% to 40% of the loans collateralizing the DBUBS 2011-LC1, MSC 2011-C1 and WFRBS 2011- C2 were refinanced from legacy CMBS transactions.

Still, the lowering of credit quality is nowhere near the levels seen in 2006 and 2007 vintages. In 2010, the market was limited to loans with a 50% to 60% LTV, and in peak 2007 vintage deals, the LTV was, in some cases, as high as 110%. "The loan quality even now is still much lower levered than what we saw in CMBS 1.0," said Kenneth Cheng, head of CMBS new issuance services at Realpoint.

CMBS 2.0 evolves from single-borrower deals to include more "conduit deals", which only contain 40 to 50 loans. This portfolio size allows the investors to better understand the portfolio.

"We have observed some deterioration in the leverage levels, but this is relative to the lower leverage levels at the beginning of 2010." Cheng said. "It is nowhere near the high leverage levels of 2006/07 [and] as the loan leverage increases, I expect the credit support levels to increase accordingly. I can only speak to Realpoint and our credit support levels are definitely more sensitive to the leverage on the loans."

According to Standard & Poor's, the credit enhancement levels for these new CMBS deals resemble 2001 and 2003 vintages with 17% to 23% credit enhancement levels to offset any deterioration in the asset class.

"The credit deterioration in more recent deals doesn't necessarily mean that the market is trending toward 2007 underwriting, but people should be watching this. It's not a new bubble but more of a cautionary note," said James Manzi, an analyst on S&P's global structured finance research group.

 

Volumes Moving to Normal

The uptick in new issuance, while encouraging, is nowhere near the levels seen in the peak years, which is a good thing. CMBS volumes dropped to $11.2 billion in 2008 from a peak of $230 billion in 2007. Less than $4 billion was sold in 2009, according to data compiled by Bloomberg. Last year, $11.5 billion was sold. JPMorgan analysts expect gross domestic CMBS supply to reach $45 billion and expect that issuance will likely accelerate to a more manageable $75 billion to $85 billion in 2012.

"Although this is well below the issuance record set at the peak of the market, it is similar to levels seen at the beginning of the previous decade and represents a run rate that we believe is sustainable," analysts said.

The demand for spread and duration should support further tightening in new issues as the year progresses. According to JPMorgan, new-issue triple-A spreads will tighten to 70 basis points over swaps, while triple-B-minus spreads will tighten to 175 basis points over swaps.

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