As the real estate market rides through the current downturn in the economy, Fitch Ratings is anticipating defaults and loan modifications to continue at least in the short term, and as an result of this, the rating agency also predicts that the number of interest shortfalls will likely rise in CMBS deals.

"With many REO loans resolving and a lot more loans going delinquent, there has been an increased volume of shortfalls that could potentially cause some rating actions to occur," said Erin Stafford, a Fitch analyst.

In most CMBS transactions, interest is distributed to the bondholders sequentially. If there is not enough interest available to pay all the certificates, a shortfall occurs in the most subordinate class of the deal. The amount of total interest shortfall determines the number of classes affected, because there will not be sufficient money to cover for the scheduled interest payments.

Fitch said that most of these shortfalls are caused by loans that experienced appraisal reduction, a process introduced to CMBS deals to limit the amount of interest advanced on a delinquent or defaulted mortgage when the collateral value has gone down.

Previously, these shortfalls primarily affected primarily non-rated CMBS classes. However, there are currently an increasing number of rated classes that have experienced shortfalls.

Though these shortfalls have resulted in some lowered ratings, Fitch has not taken any of these rated classes down to D' as of yet. Downgrading a class to D' due to interest shortfalls is necessary when there is little hope of recovering the shortfall. Further, the rating actions undertaken so far were not only a result to interest shortfalls but were also a result of other credit issues within the deal.

In a recent report, the rating agency said that it "strongly recognizes the priority of interest payments in CMBS transactions." This helps Fitch distinguish between investment-grade bonds and below-investment grade bonds when figuring out when a rating action should be taken.

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