Fitch Ratings said today that workouts of defaulted commercial mortgage loans are likely to be protracted as servicers contend with balloon risk.

The level of uncertainty surrounding commercial property sales prices and the fact that funding costs could fall after the expiry of hedging arrangements means that liquidation is viewed as a last resort.

Fitch explained that while European CMBS provides floating-rate property finance, the underlying contractual rental income used to service the bonds tends to be much more stable in nature. This creates a mismatch that is hedged via the use of swaps or caps.

After loan maturity, such hedging arrangements will typically fall away, which might create new servicing opportunities, particularly given the low interest rate environment in Europe.

"Servicers may attempt to lock in lower swap rates as a means of improving the affordability of CMBS debt service," said Euan Gatfield, senior director in Fitch's CMBS team. "This may allow for principal amortization to take place, albeit only after loan maturity and until the deadline of bond final maturity. The possibility of improved interest coverage over an extended 'tail period' might enhance the recovery prospects for some classes of note that would likely incur losses if a property fire-sale was attempted in current market conditions."

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