By Tad C. Philipp, Team Managing Director, Moody's Investors Service
U.S. CMBS issuance for the first half was approximately $26 billion, down 16% from the same period last year. Based on reports from issuers of continued slow loan production, Moody's Investors Service is maintaining its initial forecast for total volume to come in at approximately $62 billion, or 15% below last year's near record pace of $74.3 billion (the record was $77.7 billion set in 1998). International CMBS volume during the first half was approximately $12 billion and is well on the way to meeting Moody's initial forecast of $25 billion, which is maintained as well. The strong growth of international CMBS continues and may reach one-third of total issuance this year.
Several credit-related matters have contributed to the drop in issuance volume. As the market is well into a cyclical downturn, weaker credit fundamentals have caused fewer loans to pencil out to the borrower's desired proceeds.
Large-loan originations have been hindered by the lack of affordable terrorism insurance. Single-asset securitizations were a staple of last year's issuance, but there have not been any year-to-date. However, issuers have split large loans to participate among deals or have pooled them to help mitigate terrorism insurance issues and to help get things moving. At this point there is a CMBS execution for perhaps all but the largest of the large loans. There is presently some hope of a federal backstop for terrorism insurance, as discussed below; if implemented, we could see the return of single-asset transactions later this year or early next year.
The office sector continues to languish due to high vacancies and weak demand from the corporate sector. Office vacancy is currently 16% and poised to rise, and none of the 53 markets covered by Moody's Red-Yellow-Green (RYG) analysis was scored as green. We will need to see growth in corporate employment, not just earnings, to help work off some of the excess inventory that has developed. The horizon for recovery to full health now seems more distant, and may possibly slip into 2004.
The hotel sector, one of the most operationally intensive of real estate asset classes, remains in the issuance "penalty box" due to its weak recent performance. However, the worst appears to be over.
We continue to view multi-family as among the most favorable asset classes, but several issuers are pressing their limits on leverage at 80% loan-to-value (LTV), which can offset some of its intrinsic benefits. Although one of the better performing asset classes, we still take a close look at individual loans as rental concessions have crept into an increasing number of markets.
The trend of retail store closings is expected to continue for the rest of this year and into next year. The good news is that many of the shuttered spaces were leased expeditiously, albeit to lower credit quality tenants, in some cases. The bad news is that the retail sector remains volatile, and some of these re-leased spaces may return to market again at some point.
Absent the US economy experiencing a downturn far more severe than the current one, the performance of CMBS will have met or exceeded Moody's expectations. For the most part, we expect the majority of conduits to experience cumulative delinquency rates at or below 15%, which would result in the defaults of some B' rated securities and a handful of Ba' rated ones, and leave the investment-grade securities almost entirely intact.
While some markets and asset classes are experiencing problems, Moody's continues to expect this downturn to be far milder than the previous one. Of course, individual deals vary from the average profile, and some have concentrations in markets and asset classes experiencing the most difficulties in this downturn.
One concern in recent years was how all the new CMBS structures that were created in good times would hold up during a downturn. We have now had the opportunity to see them in action and have concluded that the documents, and the servicers implementing them, are generally performing as intended. However, as might be expected, some lessons have been learned and we see some room for improvement that may benefit future deals. Examples include the timing of reimbursement of non-recoverable advances, provision for unexpected expenses (such as those related to force-placed terrorism insurance), and the way in which recoveries are allocated into interest and principal. In addition, we have found instances where documents are too rigid, and we feel that servicers can be given more discretion in some areas without credit impact.
On June 18, the US Senate passed terrorism insurance bill S2600. As a result, a joint House-Senate committee will go through the process of ironing out the differences between the Senate bill and the House bill passed last November (HR3200). Among the key differences are that the House bill provides for loans to the insurance industry, while the Senate bill provides for the federal government to share in losses. The other major difference is tort reform, with the House bill having extensive curbs on punitive damage awards, while the Senate bill doesn't have any.
If and when a compromise bill is passed and signed by the President, Moody's will then closely examine the insurance industry's response. Moody's expects any federal backstop to have a positive effect on the affordability and availability of insurance, but the magnitude of the effect has yet to be determined.
We are not expecting that the resulting bill, if any, would offer the optimal long-term solution. However, assuming a bill is passed that is of value to the insurance industry, there will be strong precedent set for the government's ongoing commitment to this area.
As of late July, the House and Senate conferees have yet to be named. While always difficult to estimate the timing of legislation, it does not appear likely, at this point, that a bill will emerge before the August recess.
Terrorism insurance-related rating actions
During the second quarter, Moody's placed the Aaa' and Aa' rated tranches from 14 transactions on review for possible downgrade for reasons related to the potential inadequacy of terrorism insurance. We are now in the process of having discussions with property owners and servicers to determine their plans to address terrorism insurance issues and the security of their property, as well as other related considerations. We are prepared to take individual transactions off review as soon as we are satisfied with their level of insurance protection. The review will ultimately conclude by the end of the third quarter, taking into account any federal backstop that may be put into place by that time.
The transactions placed on review were both highly concentrated and composed of high profile assets. All involved high-rise CBD office buildings, with the exception of a Marriott hotel transaction, which includes the Marriott Marquis in New York's Times Square. At this point, Moody's doesn't expect to place mall-backed transactions on review. We view them as having less risk than office properties, given their low-rise nature and the fact that the tenants are more likely committed to the location where they make their money than are office tenants. However, a few other transactions may be placed on review at a later date as their insurance policies expire.
A key issue that is emerging is credit quality of the insurance carrier. Only a few companies providing terrorism insurance meet the traditional standard of a minimum Aa3' rating when Aaa' bonds are included in single-asset or large loan deals. Moody's has seen some proposed policies from insurers with ratings as low as Baa', and some from start-up insurance companies that are unrated. We are willing to consider various alternatives in the short run, given the dislocation in the terrorism insurance market, but, of course, we are concerned that insurance claims be paid, if the need arises.
Overall, Moody's finds that, even with the cancellation clauses and carveouts present in current policies, there is value in being insured for the next event. To the extent one occurs, if the government hasn't already passed a terrorism insurance bill by that time, the likelihood of passage would become even greater. Although terrorism risk remains difficult, if not impossible to quantify, we feel that it is not prudent to ignore it, particularly on the highest investment-grade securities from single-asset transactions. The fact that it is hard to buy such insurance for full coverage - and, if you can, it is likely to have carveouts - is enough to raise concern that, in some cases, it may not be a risk appropriate at a Aaa' level.