With volatile economic conditions and the havoc caused by the recent terrorism attacks on the World Trade Center, CMBS analysts are starting to look at the components of the deals' structures, especially in light of the fact that the sector has, until recently, existed in a low-stress environment.

In a teleconference last week, analysts from Moody's Investors Service warned that delinquency rates on commercial mortgage loans may rise and CMBS structures may increasingly be tested going forward. The ratio of upgrades to downgrades on CMBS deals, which has always been heavily in favor of the former, would probably balance out due to current conditions.

And investors are not slow to react to the likelihood of an increasingly more volatile sector.

"In the long run we expect the major impact of the attack will

be increased investor focus in on the slowing economy and the impact that may have on loan defaults that cause early bond repayments," said Darrell Wheeler, director of CMBS research at Salomon Smith Barney. "At the beginning of the year we had suggested a recession default scenario for investors to value premium CMBS bonds. Yet most CMBS investors have been pricing to an even more severe recession scenario.

"Wheeler said that this cautious approach to commercial real estate by investors is a direct result of the previous real estate recession suffered in the early 1990s. "Ironically, this lender and investor caution has actually created very strong commercial real estate fundamentals, which we expect should enable CMBS to be one of the better investments in the current recession," he stated.

And with the delinquency rates on the uptick and the uncertainty clouding World Trade Center CMBS deals, components of the CMBS structure that come into play during times of stress are starting to be re-examined.

"One of the current hot topics is advancing," said Tad Philipp, managing director in charge of commercial mortgage finance at Moody's. "What I think needs to be done is to tighten up the documents so that the servicers could advance not only on the value of the building but on any insurance proceeds that go with it."

Philipp explained that in some cases documents can be drafted where the servicer can look to the value of the property for recovery. However, with this kind of policy in place, questions would arise when, as in the case of the WTC deals, the property is destroyed. But, if servicers look not only to the value of the property, but also to the insurance that might be available, that would make the obligation to advance much more clear.

In a recent report, Nomura Securities said there would be a need for post-WTC deals to make clear guidelines as to who has first claim on insurance proceeds. The report said that even if the servicer has first claim on the proceeds, it might not suffice in all cases especially if the insurance company takes a long time to pay. This would not be good for holders of subordinate CMBS tranches.

Another problem is that typically the insurance only covers the cost of the building, while the loan amount also gives some value to the land. This causes a discrepancy between the insurance proceeds and the loan amount.

Going forward, analysts expect that there would be closer communication between rating agencies and servicers brought about not only by the WTC situation but also by the expectation of rising delinquencies, especially in the hotel sector. This would cause rating agencies to have a better grasp of the performance of specific servicers.

"Our opinion of the quality of servicers so far has largely been based on how we thought they would perform," said Philipp. "Now we will have more direct information as we work with them. The pack will separate and some servicers and trustees may distinguish themselves and some may not. Their performance during times of distress will be taken into consideration in our assessment of their acceptability for future Moody's rated transactions."

Tail periods

Another aspect of CMBS transactions that was talked about in the Moody's press conference were tail periods.

A tail period, typically about two to three years, is the mismatch between the maturity of the bonds that were rated and the actual maturity of the mortgage. A loan, for instance, can have a five-year stated maturity, but have an eight-year final maturity.

Analysts said that from the perspective of more junior bond holders, a longer tail period is helpful to maximize recovery on a loan. Recovery on the property would be greater if the borrower had two to three years wherein to liquidate the loan in a more orderly manner than if the borrower were forced to liquidate or refinance in a forced situation, because in two to three years, commercial real estate fundamentals may change, and the chances of recovery on the loan would be better as time passes.

However, some senior investors do not like tail periods because there is uncertainty as to when they could get their money back or some of them have internal guidelines where they can only invest in five-year deals, for instance, and the tail causes problems in this case.

Moody's believes that generally three years is the minimum amount of time that is necessary for the orderly liquidation of a CMBS loan. However, in many cases, depending on the location of the property and the complexity of the loss, the rating agency would rather have a five-year tail period. For instance, the foreclosure process in New York takes longer than in Texas so the tail period required in New York properties may be longer than that in other states.

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