With credit spreads tightening and defaults falling by the wayside, CMBS transactions have seen a recent ease in credit and structural protection, causing concern among CMBS market participants. Just last week, research from Nomura Securities International focused on this topic while Merrill Lynch looked at the higher leverage in IO loans potentially leading to extension risk.
Analysts at Nomura studied the different elements of credit standards and structural enhancements, specifically at LTV and subordination levels. The report stated that normally subordination levels should increase as LTVs rise, but based on the data, the opposite has been happening. Analysts report that recent enhancement levels and leverage ratios appear to be reaching the point where the market is positioned for a best-case scenario and the more recent vintages would probably be unable to handle stress, as well as seasoned vintages. Nomura said it is imperative to carefully scrutinize loans especially at the lower end of the capital structure.
Nomura also warned against the possibility of less cross-collateralization and diminishing loan reserves and escrows in CMBS deals. The firm's analysis shows that not only are fewer loans requiring reserves, but the amounts of the reserves have also dipped, which could lead to increased loss severity should a loan get into trouble. Analysts stated that this is something to be wary of in 2003 to 2005 vintages, particularly in light of increased IO production as rates rise.
Nomura also cited the weakening standards in anticipated repayment date loans. This loan type, although legally fully amortizing, is made with strong borrower disincentives to prepay - such as a step-up in the interest rate and trapping and the application of excess cashflow for paying down principal. Analysts said that in some recent cases, the language describing these loans has changed. In certain loan documents, the step-up rate is not linked to market rates but merely set at 2% above the initial mortgage rate.
Analysts attribute the current easing in lending standards to the compression of credit spreads across products, including CMBS, and the considerable dip in defaults in the different markets.
"Given the fiercely competitive lending environment and relatively benign credit outlook, we very much doubt that the trend towards weaker lending standards will reverse itself anytime soon," Nomura analysts wrote, adding that they expect lenders, especially some newer entrants - aiming to gain market share - to cut corners.
There is nothing inherently wrong with easing standards as long as investors and lenders are compensated for the additional risk, Nomura said, adding that CMBS investors should carefully select vintages and originators, where differences in performance exist. Rating agencies could revert back to requiring more credit enhancement, Nomura warned, resulting in wider spreads on existing deals, particularly newer ones where the deals have not de-levered.
Separately, Merrill Lynch wrote about the increased frequency of higher leverage in IO loans at the balloon date, which could result in CMBS extension risk. Analysts said that recent IO originations probably have higher balloon LTVs versus amortizing loans. They added that IO loans tend to be some of the biggest loans in the deals - with an average balance three times more than the average balance on traditional mortgages. Consequently, borrowers with recently originated loans could have a harder time refinancing should rates rise, a problem compounded by the lack of amortization resulting from IO loan proliferation.
Merrill Lynch argues that the balloon LTV on more recent IO mortgages have risen and are now considerably larger versus amortizing counterparts. To test this assumption, Merrill broke down and analyzed conduit loans securitized since 2003 into term IO loans, period IO loans and non-IO loans.
For these three sub-sets to have similar refinance risks at the balloon date, term IO loans should have had the lowest LTV at securitization, non-IO loans the highest and period IO loans in the middle, analysts said. Lower LTVs should compensate for the loan's non-amortizing feature. Results show that 2003 vintage loans followed this pattern but leverage shifted for more recent cohorts.
The estimated reset date LTVs were higher on IOs, versus non-IOs for deals in the past year, diverging from earlier trends. Further, though LTVs have risen for both period and term IO loans, analysts are slightly more concerned about period IO loan credit quality. By contrast to IO loans, where payment is reduced over the mortgage's term, the reduced payment is only temporary in period IOs.
Merrill analysts added that while IO loans are not inherently bad if properly underwritten, investors should evaluate whether these loans increase extension risk in deals they buy. With current interest rates, IO proliferation and lax underwriting, Street analysts believe loan extensions will be a growing phenomenon especially for 2004 and 2005 vintages.
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