The CMBS market has been running strong for some time, as CMBS deals have, until recently, been considered a relatively cheap means of financing, serving as a popular way to fund buyouts, for example. Yet growth has come at the expense of deal quality. In April, the three rating agencies fired off a set of comments indicating that commercial mortgage underwriting was showing troubling signs of deterioration (Fitch Ratings, for one, predicts that 2007 vintage loans could have a 15% greater default rate than previous years). Culprits include CMBS so highly leveraged that borrowers need additional financing just to handle debt servicing, along with a larger number of poor-quality loans shoehorned into B-pieces of CMBS
The trend to looser underwriting standards "has been ratcheting up over time, as real estate has been in a really strong cycle," said Zanda Lynn, a Fitch managing director. After all, more than $800 billion in commercial mortgage bonds are outstanding, as of earlier this year. Lynn said Fitch's recent warning about CMBS credit quality was a response to what the agency witnessed in the first quarter, when some loan underwriters "made the move from aggressive to egregious."
While Fitch and Standard & Poor's have not altered any of their current CMBS rating models to date, Moody's Investors Service, beginning in April, began phasing in a stricter set of
subordination requirements for new commercial mortgage bonds. To merit an Aaa' rating on a junior class of a CMBS conduit transaction, issuers will now have to have subordination levels in the 14% range, as opposed to the 11% range in the recent past.
Because the CMBS market has a relatively slow securitization process compared with the asset-backed or residential mortgage markets, the new Moody's mandates are taking months to have any discernable impact. Moody's itself noted that the first CMBS deals to reflect the
subordination level adjustment should not hit the market until July 1 or later.
Several CMBS underwriters, speaking not for attribution, said they saw the recent rating agency moves as a pre-emptive strike of sorts, arguing that the agencies appear to be trying to avoid a meltdown similar to what has occurred in subprime residential mortgages by getting ahead of the game and trying to reduce the dicier practices in commercial mortgages before any serious defaults occur. Among the worst offenses is the recent uptick in interest-only loans, especially those with extremely long periods (10 years, for instance), which in some cases offer protection against loan losses only in the 4% range.
Underwriters said some confusion and foot-dragging have occurred in the CMBS market since the agencies began firing their salvos, in part because no one knows what changes will be implemented or what the impact could be on new deal issuance and pricing in the secondary market. "The market ultimately hates uncertainty more than anything else," said one CMBS head at a top-ranked bank.
In the past few weeks, however, underwriters said things appear to have stabilized, with both Fitch and S&P making no signs of changing their playbooks. While no CMBS deal in the upcoming pipeline has been pulled due to the uncertainty, nearly all of the deals have undergone restructuring, with some poorer-quality loans getting the hook.
"There are a lot of deals getting rejiggered," the CMBS underwriter said. "Every dealer without exception has had several loans removed from the pools."
To comply with the new Moody's requirements, many underwriters plan to spread out poorer-quality loans over a longer period of time, or restructure previously made loans, rather than clear out their existing loan stockpiles entirely. One suggestion by Moody's analysts Jim Duca, Tad Philipp and Sally Gordon was "that issuers may carve a B-rated note out of a previously originated whole loan so that the leverage of the senior portion contributed to a CMBS is more aligned with leverage levels of several quarters ago."
Calling a Halt
Around the same time that Moody's announced its new subordination standards, Fitch publicly spoke out on what it considered a growing trend toward loosely underwritten commercial property deals, featuring, for example, loan-to-value ratios over 100% and loans that, even at the outset, already have debt service shortfalls, forcing owners to borrow more up front to pay current debt service.
For a good part of the decade, lenders typically underwrote commercial mortgage deals based primarily on a property's historical net operating income, but in the past two years, more and more lenders have begun basing loans on future cash flows, essentially betting that prices of commercial real estate will continue to rise. The trend began in earnest in 2006 and reached a critical mass in the first few months of this year.
"Last year, it was more case by case, but by [this] April, it had reached the point where basically everybody was doing it," said Eric Rothfeld, a Fitch senior director.
Among the worst offenders were hotel deals whose cash flows were derived from revenue from planned improvements yet to be completed, and, most notably, the condo conversion market, which Fitch said is already generating a fair share of delinquencies and defaults. The problem with these condo loans is that their valuation was based in part on future value growth, but due to cooling real estate markets, a number of condos are being turned into rental units, and the rental value of a property is typically far less than the anticipated condo conversion value. To, no surprise, some condo developers can no longer meet debt obligations.
Since April, there are signs that deal quality has improved, analysts and underwriters said. Large loans are being cut more conservatively, IO loans are fewer (and those that have come to market have had shorter maturities), and amortization has increased slightly.
The verdict is out, however, on whether the changes will be widespread or vigorous enough to head off any serious overall declines in CMBS credit quality.
"Everyone is talking the right talk now, but while part of the industry will definitely follow through, I don't think everybody will, and there will be more of a tiering effect for originators," Lynn said. "We've heard a lot of talk about new underwriting, but it hasn't filtered in to us yet." She did note that subordination levels were about 10% higher on average in the second quarter than in the first, a positive sign.
As for CMBS underwriters, they agreed that the rating agencies' actions can have only so much influence on the market's direction. Rather, the key question is whether CMBS investors, and B-piece buyers in particular, will use the rating agency concerns to push for higher-quality deals.
"If rating agencies enforce a little bit of discipline, investors usually enforce the rest," one banker said. "Investors need gas in their tank, so the agencies primed the pump a little bit. Investors are usually a good enforcer of stricter discipline."
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