With rising delinquencies and declining property values, interest shortfalls may occur more frequently on rated CMBS classes, negatively impacting the ratings on those classes.

Standard and Poor's said that as of October 2001 about 80 multi-borrower transactions had accumulated interest shortfalls out of 248 rated CMBS deals. The rating agency stated that most of the shortfalls occurred in subordinated certificates that were not rated by S&P.

However, S&P said that if a "material amount"- which is an important point because some shortfalls only amount to a few hundred dollars - of interest shortfalls will accumulate for a certain certificate, and are not expected to be reimbursed in a timely fashion, the rating on the certificate will most likely be lowered, often to "D". This can happen even if a given CMBS deal has no loans in monetary default because if shortfalls reach a "material amount" the rating agency already considers them as defaults.

"Our ratings speak to timely payment of principal and interest," said Roy Chun, a director at S&P.

According to the S&P report, so far this year there have been six transactions that had been downgraded with interest shortfalls on rated classes.

In evaluating the extent of the shortfalls, the rating agency carefully reviews the circumstances in which these occur, which varies from transaction to transaction.

According to S&P associate director Eric Thompson, there are cases, for instance, where the trust could incur expenses such as legal fees, which may only be a one-time occurrence. The shortfalls would first affect the subordinate classes and then to the extent the shortfalls exceed the interest payments on the subordinated certificates, shortfalls can occur.

If the B-rated tranches, for instance, were impacted by the interest shortfall due to the legal expenses, it may still be deemed recoverable. Typically, the way the structure works is that in the following month after the shortfall, the B bondholders are usually paid the cumulative shortfall amount before the certificates that are subordinate to them get paid current-month interest.

"So it could be the case that just by the mechanics of the waterfall that we know for a fact that double- B will get paid back full in the subsequent month to the period in which the shortfall occurred," said Thompson. "In that case, and depending on the circumstances, we may not set it to D'".

Reasons for the shortfalls

S&P said that appraisal reductions were the major cause of interest shortfalls both in terms of the number of shortfalls and the dollar amount.

Most CMBS deals have the advancing mechanism where if the underlying loan becomes delinquent, a servicer or a trustee can advance payment on the loan. But if a portion of the loan is considered unrecoverable, then servicers usually use the Appraisal Subordinated Entitlement Reduction Amounts (ASERS), which allows servicers to limit their advances on a given loan.

According to the report, ASERS are generally "interest due on the ARA amount, which is the excess of the total exposure on a given delinquent loan over an amount equal to 90% of the underlying properties most recent appraised value." This amount is defined in the pooling and servicing agreement.

Interest shortfalls are also caused by trust expenses such as special servicing fees and disposition fees that are paid out of a certain loan pool's interest collections in a given month.

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