Leading up to the release of the CMBX 07-1 index last week, concern was mounting regarding the credit quality of recently issued commercial mortgages. Seen by many as the most aggressive of the rating agencies on the topic, Moody's Investors Service earlier this month announced it would require more credit enhancement for CMBS deals amid worsening underwriting standards.
The announcement caused a number of CDO issuers, who had not already done so, to reevaluate their commercial mortgage portfolios for fear of suffering the mark-to-market pain felt by those caught warehousing HEL collateral. Meanwhile, those with a short interest are widely expected to step into the sector via single-name CDS as well as the newest CMBX index in search of value, sources said. This has led many to wonder: How bad has CMBS underwriting become?
Collateral characteristics of the CMBX 07-1 offer some indication.
The triple-B, triple-B-minus and double-B sub-indices of the CMBX 07-1 index have 50 to 60 basis points less subordination than deals included in the CMBX 06-1, and 30 to 40 basis points less than the CMBX 06-2, according to Bear Stearns.
The average LTV of deals included in the CMBX 07-1 is 3.6%, and 3.9% higher than the LTV of deals included in the CMBX 06-2, according to Fitch Ratings' and Standard & Poor's respective methodologies. Meanwhile, the leverage is 8.2% higher based on Moody's methodology, Bear Stearns reported.
Perhaps most striking, the proportion of full-term interest-only loans increased to 49.8% in the CMBX 07-1 from 27.9% in the CMBX 06-2.
The fact that recently issued deals might rely on overly optimistic estimates of future cash flows is, to some investors, the largest challenge 2007 vintage CMBS face.
Speaking during a rating agency round table on the topic hosted by Bear on April 19, Moody's analyst Tad Philipp said the 10-year track record of CMBS performance is "almost dangerous because it has been so good." One investor speculated that the 2007 vintage would be "wildly different" than the 2006 vintage, based on higher leverage, thinner subordination and lagging home price appreciation.
While Moody's is the only rating agency that has systematically increased required subordination levels for the sector, Fitch and S&P have also said they are increasing subordination, but on a deal-by-deal basis.
Moody's earlier this month said it would "likely" increase CMBS subordination levels to compensate for the increased credit risk. "The subprime elephant in the room' has generally renewed attention on credit in other sectors," Moody's analysts wrote at the time. "The parallels between underwriting developments in the subprime and CMBS markets are striking ... and indicate that acting now should help mitigate potential CMBS losses in a future downturn."
The fact that CMBS risk is often leveraged through CDOs subsequently rated by Moody's was a driving force behind ensuring the rating agency "get the ratings right," Philipp said during the round table. He later added that the agency does not have plans to change its CRE CDO model.
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