Even while prepayments in the residential mortgage market cool down, the number of commercial mortgage borrowers currently prepaying their loans is not only soaring but anticipated to accelerate through year-end and into 1Q06, according to Wachovia Securities analysts. For the CDOs backed by CMBS and other commercial real estate assets that indicates a chance that performance could be boosted, resulting in upgrades. In the same manner, increased call options on unsecured credit obligations have accelerated paydowns in the later-vintage high-yield CDO market (see ASR 8/22/05).
"In the coming months, already accelerating defeasance levels will likely be boosted by year-end's approach, rising short-term rates, a flattening yield curve and strong property markets for which valuations typically lag rising interest rates," Wachovia analysts wrote, noting that one of the main deterrents from commercial property valuations - cap rates - typically follow several months behind interest rate changes.
Wachovia identified 207 CMBS tranches within 124 CMBS deals that have either a so-called medium or high probability of receiving an upgrade in the near future due to defeasance. Most likely to be upgraded are the more seasoned vintages, from 1999 through 2003, rated double-A through double-B, as well as interest-only and commercial real estate CDO with strong performing collateral. In particular, CDOs backed by CMBS B-pieces could stand to be the biggest beneficiaries of the trend, according to Wachovia.
So far this year, the total dollar volume of CMBS loans that have defeased - meaning the borrower, per contract, has prepayed the loan by matching its principal and interest payments within its REMIC trust with U.S. Treasury cash flows - has reached more than 3.5 times that of last year. Some 1,594 loans totaling greater than $19 billion have defeased, compared with $5.3 billion seen in 2004; only 196, 35, 18 and three loans defeased in 2003, 2002, 2001 and 2000, respectively.
The defeasance surge is a testament to rising commercial real estate values - without which the option of matching the higher-yielding commercial loan cash flows with higher priced and lower yielding U.S. Treasurys would not be a very economical choice, said Wachovia.
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