The pricing of CREST 2004-1 by Wachovia Securities last week was just the third CDO comprised of CMBS collateral - subordinate CMBS collateral that is - to ever hit the market. This innovative revolving structure, which debuted in late June, marks a true milestone as CDO technology converges with the asset-backed market in a structure that has investors buying in large portions.

While structured finance CDOs are nothing new, harnessing the power of a mix of B-level commercial mortgage securities had not been tried before this year. The first CDO of this kind was Capital Trust RE CDO 2004-1, a cash flow CDO underwritten by Morgan Stanley and GMAC Commercial Holding Capital Markets, with Bear Stearns and Goldman Sachs on board. That $324 million arbitrage deal issued floating rate notes in a revolving structure. Its two triple-A rated tranches bore a weighted average life of 4.27 years and 4.80 years and priced at Libor plus 33 and Libor plus 45, respectively.

CREST, on the other hand, was a $425.5 million arbitrage, cash-flow transaction structured into 14 different tranches, including preferred shares, with ratings ranging from triple-A down to the double-B level. The $184.2 million senior A class, with an average life of 6.8 years, priced at a tight Libor plus 33 basis points. The $44 million double-A rated B1 tranche, with a 9.1-year average life, priced at Libor plus 49.

Plenty of CMBS lenders have these types of subordinate, or B, class notes on their books, perhaps better described as the junior portion of senior mortgage loans. In the deals seen thus far, these notes have been mixed into a CDO pool with mezzanine loans and other types of subordinated debt such as credit tenant leases, bridge loans, CMBS certificates, and commercial mortgage whole loans. The emergence of three deals this year has sparked hope that more CDOs of this variety will be seen in 2005.

CMBS securities tend to be longer dated, while the B notes and floating rate loans tend to be shorter, typically two years. "If you have a two-year weighted average life on your portfolio, it's going to wind down very quickly. In many cases its cost prohibitive to do a two-year deal," said H.J. Kim, a director in the CDO group at Fitch Ratings. "But the key to this structure is that it's revolving, the loans amortize and mature, the principle proceeds from that can be used to acquire additional collateral." said Kim.

The three CDO transactions executed to date also includes Brascan Real Estate CDO 2004-1, Wachovia's first CDO of this type, which priced in September. Joined by co-underwriter Goldman, the deal saw a $191.1 million A-level tranche with a 5.9-year average life priced at Libor plus 35 and a $32.35 million B-level tranche with a 6-year average life priced at Libor plus 55.

"I truly think demand will continue into next year," added Kim, pointing to the blossoming level of mezzanine high yield real estate funds that have cropped up recently, from Guggenheim to New Star. The emergence of this new investor class is expected to drive issuance of revolving B-note CDOs.

"They are out there looking for high yielding real estate assets. A lot of these loans tends to be to transitional properties financed, traditionally, through short term floating rate notes," said Kim. Larger floating rate loans tend to be carved into A and B notes, with A notes going into large loan or conduits. But whereas B-notes were once placed with buy and hold asset managers, the CDO market has created an innovative way to create efficient financing.

In an interesting twist, a typical CDO is comprised of publicly rated securities but the collateral packed into these revolving B-note CDOs is unrated. Fitch released its methodology for rating these new vehicles late last month.

"This is a critical feature of the revolving B-note CDO," said Kim, pointing to the Capital Trust transaction. None of the loans in the transaction were rated, so Fitch incorporated the expertise of both its CDO group and its CMBS groups to create internal ratings assessments on the loans.

But participating in this new CDO requires more than just thirst for new collateral types. Investors need to be aware that the B-notes and mezzanine loans packed into these deals have different legal parameters than the typical CDO collateral. Both are generally first-loss pieces. And in a default, investors need to be aware that B class notes vary in terms of controlling rights, so inter-creditor agreements limit the rights of holders.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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