[Excerpted from the paper "The CMBS Market In The New Millennium"]

In 1999 investors developed the concept of different CMBS pricing based on perceived underwriter quality and transaction liquidity. Tiering CMBS transactions for liquidity made sense because the events of 1998 removed some issuers from the market, creating orphan issues with no broker specifically committed to providing a market.

The second factor was based on a conception of "credit culture," which the market suggests is stronger in bank-based originators. Credit culture is the idea that some institutions have underwriting checks by third parties whose compensation is in no way tied to issuance volume.

However, the rating agencies review the underwriter's credit origination process and adjust credit enhancement levels to account for their analysis. Agencies' opinions on an underwriter are contained in the presale report and, in our experience, can cause a subordination variance of up to 2% between transactions.

The extra subordination built into some transactions may mean investors are overcompensating for issuer quality with the additional spread premium. We have analyzed CMBS default rates by issuer but, given the current strong real estate environment, are unable to detect a meaningful relationship between issuer and loan performance.

To date loan defaults could be best described as random events. In general, defaults are higher in floating-rate transactions and on retail properties. The retail defaults have occurred usually when an asset is highly dependent on a specific, single tenant for cash flow. Our database of losses showed a $33 million loss on an entire CMBS pool of $233 billion, which appears impressive relative to other asset-backed securities.

However, the current economic environment is not a good recession test of the CMBS credit-enhancement structure, and none of these pools has aged to the typical ten-year balloon test date. We expect that when we go through the next recession a default pattern will develop based on origination year, underwriting quality, and property type.

Delinquency rates continue to be important, as any delinquency immediately affects a CMBS transaction's liquidity and price. This spread widening is well acknowledged as illogical, given that some defaults were originally projected for all CMBS transactions and are unlikely to create an investment-grade principal loss.

However, given that spreads quickly widen on any bad, deal-specific news, investors have actively bid for transactions with low expected default rates, creating the current credit-tiered market.

Although highly subordinated transactions may experience more defaults, they are unlikely to remain on credit watch for long periods because the extra credit enhancement usually enables the rating agency to affirm levels quickly. In 1999 a good example of the benefits of high subordination came from three credit tenant lease (CTL) transactions that contained a large amount of Rite Aid exposure.

November Moody's downgraded Rite Aid to B1, putting three CTL transactions on credit watch. Although MLMI 1998 CTL had more than 20% Rite Aid exposure and the other two transactions had less than 10% exposure, MLMI also contained almost twice the credit enhancement of the other CTL transactions. This enabled Moody's to quickly affirm MLMI, while the other transactions remained on credit watch.

Transactions vary and this simple example may not always apply. However, in general, transactions with high credit subordination levels have extra default and loss protection and may weather a recession better than lower subordinated transactions. Specifically a transaction with 1% extra subordination at the AAA level can withstand 2.5% more loan defaults than a pool with lesser subordination (assuming a 40% loan loss rate).

Long-term CMBS investors will find value in the lower-tier CMBS categories, which have greater subordination and wider spreads, while short-term CMBS investors that mark to market should stick with the tier 1 and 2 categories to avoid defaults and the resulting immediate spread widening. In 1999 the market actively bid tier 1 and 2 issues, while tier 3 transactions had limited liquidity. This trading pattern suggests there may be more relative value in the tier 3 transactions.

Over time, as the CMBS market experiences more defaults, investors should grow more comfortable with defaults, reducing the underwriter price differentiation currently in the market.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.