The lack of liquidity in the structured finance market is beginning to hinder the ability of CMBS issuers to originate loans at the same clip they were doing in the first half of the year. With a much slower pace of origination, the deals become more concentrated, according to Moody's Investors Service.
Since CMBS deals are not normally very diverse in the first place, they "are on the frontier of where loan diversity becomes a significant credit issue," according to a recent report written by Moody's analysts. The Herf score allows the rating agency to make sure each deal is properly enhanced.
Moody's is measuring a deal's diversity level through the Herfindahl score, which evaluates the level of loan concentration. The higher the Herf score, the lower the loan concentration is likely to be in a deal, while a lower score indicates a higher concentration. The Herf score applied by the agency is the inverse of the Herfindahl-Hirschman Index used by the U.S. Department of Justice to measure the size of firms in relation to their industry.
When origination activity was up, there were numerous deals with 200 loans, translating into a Herf score of 70. A lot of the most recent deals are scoring a Herf of 40, with the worst-case scenario being scores in the 20s. Deals are almost twice as concentrated as last year.
Moody's tracked the increasing concentration levels of CMBS loan pools, which could lead to higher delinquencies and increased ratings volatility.
Moody's wrote its latest report because investors might see deals in the fourth quarter with lower leverage and trade off lower subordination levels for a better deal. "What we're finding is the increased concentration of pools is causing us to have higher subordination levels, and as a result, we might not be asked to rate the deal, and we wanted to highlight this so that investors would be fully aware," said Paolo Obias, a managing director at Moody's.
Obias said the CMBS market still remains strong, despite the credit crunch weighing down the RMBS market. Analysts from Wachovia Capital Markets supported this assessment in a recent report that offered a positive outlook for commercial real estate. About 94% of the 200 CRE markets tracked by Wachovia analysts are forecast to be stable or revenue growth markets, which "should temper the inevitable rise in CMBS defaults from current historical lows," according to the report.
But Obias also noted that the concentration levels for future CMBS deals going forward could continue to rise, which would put the loans at risk of increased delinquencies. "It's possible, but we don't know for sure," he said. "It depends on deals we see in the future, but at this point there clearly has been a decline in the Herf score in the third quarter of this year compared to the third quarter of last year."
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