Delinquencies Reach New Lows but Defaults Persist in CMBS

Resolution of distressed legacy CMBS has helped improve delinquencies in the market but it doesn’t mean that these deals have escaped downgrades.

In June, Trepp reported that the CMBS delinquency rate posted a 42-basis-point drop to 8.65%, the lowest level in almost three years. June was the first time the rate has dropped below 9% since November 2010 and the lowest percentage since October 2010.

Driving the rate down last month was over two billion dollars of loan resolutions, which rose sharply from May’s total of $858 million. “Part of the reason that the delinquency rate has come down is because legacy loans have paid off, those loans that went into special servicing have been liquidated,” said John Kemp a director of CMBS surveillance at Standard & Poor’s.

The bad news is that interest shortfalls, accumulating over the last few years as a result of those assets being in special servicing, still exits; unless the loans paid off the principal amount and the past due interest – which very rarely happens, said Kemp.

In some CMBS transactions, mostly on 2006 and 2007 vintages, there continues to be a troubling accumulation of interest shortfalls.

Standard & Poor’s said in a report on Friday that it downgraded 19 ratings from 6 transactions based on current and potential interest shortfalls.

S&P lowered its ratings on 11 of these classes to ‘D’ because the accumulated interest shortfalls are likely to remain outstanding for the “foreseeable future.”  These notes have had accumulated interest shortfalls outstanding for six to 10 months.

Those interest shortfalls are due mainly to revalued assets that had been transferred into special servicing.

Once in special servicing distressed assets undergo an appraisal reduction amount (ARA) that determines the assets new value.

Since the distressed asset is no longer worth what it was at issuance, it provides less interest payments to the CMBS trust.

“Those assets, which have received an ARA, give a reduced amount of interest to the trust and as a result the bondholders on the bottom of the waterfall are receiving less interest and those interest shortfalls continue to accumulate until those assets are sold,” said Kemp.  

Fitch Ratings cited similar concerns in a June report. Nearly 90% of CMBS that came out before 2009 and are still alive suffer from interest shortfalls, according to the report.

So why does the delinquency rate continue to improve? The delinquency rate is for all of the outstanding bonds that exist in the CMBS universe and it is nowhere near the 1% rate seen in 2002 and 2003, explained Kemp.

In many respects, the damage to the delinquency rate has already been done by the 2006 and 2007 vintages.  But while these distressed loans may have been transferred out of special servicing, the interest shortfalls to the trust accumalated.

“You have a situation where there are distressed assets that are liquidating and they are paying off, which lowers the amount of delinquencies; but at the same time those individual deals where the interest shortfalls built up usually hasn’t gone away so those bonds are receiving less interest and as result they are downgraded,” said Kemp.