CMBS

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Commercial mortgage-backed securities (CMBS) are a type of bond commonly issued in American securities markets. They are a type of mortgage-backed security backed by mortgages on commercial rather than residential real estate. CMBS issues are usually structured as multiple tranches, similar to CMOs, rather than typical residential "passthroughs."

Many American CMBSs carry less prepayment risk than other MBS types, thanks to the structure of commercial mortgages. Commercial mortgages often contain lockout provisions after which they can be subject to defeasance, yield maintenance and prepayment penalties to protect bondholders.

European CMBS issues typically have less prepayment protection. Interest on the bonds is usually floating, i.e. based on a benchmark (like LIBOR/EURIBOR) plus a spread.

Contents

Organization

The following is a descriptive passage from the "Borrower Guide to CMBS" published by the Commercial Mortgage Securities Association and the Mortgage Banker's Association[1]:

Commercial real estate first mortgage debt is generally broken down into two basic categories: (1) loans to be securitized ("CMBS loans") and (2) portfolio loans. Portfolio loans are originated by a lender and held on its balance sheet through maturity.

In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled and transferred to a trust. The trust issues a series of bonds that may vary in yield, duration and payment priority. Nationally recognized rating agencies then assign credit ratings to the various bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is subordinate to the lowest rated bond class.

Investors choose which CMBS bonds to purchase based on the level of credit risk/yield/duration that they seek. Each month the interest received from all of the pooled loans is paid to the investors, starting with those investors holding the highest rated bonds, until all accrued interest on those bonds is paid. Then interest is paid to the holders of the next highest rated bonds and so on. The same thing occurs with principal as payments are received.

This sequential payment structure is generally referred to as the "waterfall". If there is a shortfall in contractual loan payments from the Borrowers or if loan collateral is liquidated and does not generate sufficient proceeds to meet payments on all bond classes, the investors in the most subordinate bond class will incur a loss with further losses impacting more senior classes in reverse order of priority.

The typical structure for the securitization of commercial real estate loans is a real estate mortgage investment conduit (REMIC). A REMIC is a creation of the tax law that allows the trust to be a pass-through entity which is not subject to tax at the trust level. The CMBS transaction is structured and priced based on the assumption that it will not be subject to tax with respect to its activities; therefore, compliance with REMIC regulations is essential. CMBS has become an attractive capital source for commercial mortgage lending because the bonds backed by a pool of loans are generally worth more than the sum of the value of the whole loans. The enhanced liquidity and structure of CMBS attracts a broader range of investors to the commercial mortgage market. This value creation effect allows loans intended for securitization to be aggressively priced, benefiting Borrowers.

Industry Participants

Primary Servicer (or Sub-Servicer)

In some cases the Borrower may deal with a Primary Servicer that may also be the loan originator or Mortgage Banker who sourced the loan. The Primary Servicer maintains the direct Borrower contact, and the Master Servicer may sub-contract certain loan administration duties to the Primary or Sub-Servicer.

Master Servicer

The Master Servicer’s responsibility is to service the loans in the pool through maturity unless the Borrower defaults. The Master Servicer manages the flow of payments and information and is responsible for the ongoing interaction with the performing Borrower.

Special Servicer

Upon the occurrence of certain specified events, primarily a default, the administration of the loan is transferred to the Special Servicer. Besides handling defaulted loans, the Special Servicer also has approval authority over material servicing actions, such as loan assumptions.

Directing Certificateholder / Controlling Class / B-Piece Buyer

The most subordinate bond class outstanding at any given point is considered to be the Directing Certificateholder, also referred to as the Controlling Class. The investor in the most subordinate bond classes is commonly referred to as the “B-piece Buyer.” B-piece Buyers generally purchase the B-rated and BB/Ba-rated bond classes along with the unrated class.

Trustee

The Trustee’s primary role is to hold all the loan documents and distribute payments received from the Master Servicer to the bondholders. Although the Trustee is typically given broad authority with respect to certain aspects of the loan under the PSA [Pooling and Servicing Agreement], the Trustee typically delegates its authority to either the Special Servicer or the Master Servicer.

Rating Agency

There will be as few as one and as many as four Rating Agencies involved in rating a securitization. Rating agencies establish bond ratings for each bond class at the time the securitization is closed. They also monitor the pool’s performance and update ratings for investors based on performance, delinquency and potential loss events affecting the loans within the trust.

CMBS and TALF

Source: FT Alphaville, June 29, 2009

"S&P’s ruminations on reforming the way it rates commercial mortgage-backed securities, or CMBS, has become a hot topic since the agency made its request for comment on the changes back in May.

Not only do the potential changes have implications for banks, which may find $235bn worth of AAA-rated CMBS suddenly downgraded, it also has implications for CDOs, and the Federal Reserve’s Talf programme, which requires eligible CMBS to have only triple-A ratings.

In any case, S&P on Friday released its updated proposed methodology on Friday. The various documents make for very interesting reading, in particular the agency’s new criteria for credit enhancement or credit support, which cushions against potential losses. The agency wants CMBS credit enhancement levels sufficient for AAA-rated tranches to be able to withstand some pretty severe declines (40 to 50 per cent) in the value of commercial property.

Here’s S&P on its proposed credit enhancement level:

The centerpiece of these updated criteria is the specification of an “archetypical pool” and its associated credit enhancement level at the ‘AAA’ rating category. Under our revised criteria, our analysis led us to arrive at a ‘AAA’ credit enhancement figure of 19% for the archetype pool. This represents a major recalibration of our CMBS criteria and is intended to enhance the comparability of U.S. CMBS ratings with ratings in other sectors, such as U.S. corporates, U.S. municipals, sovereigns, and other areas of structured finance. Many respondents to the request for comment stated that we appeared to be “backing into” a ‘AAA’ credit enhancement level of 20%, and commented that the selection of this figure seemed “arbitrary.” In fact, we based our decision to set credit enhancement levels to approximately that level on numerous factors [including the potential property declines mentioned above]. . .

One of those factors was the historical trend in the level CMBS credit enhancement. It looks like this:

Image:US CMBS.jpg

o S&P’s new 19 per cent target is trending towards the level predominant in 2002 and 2003. Unsurprisingly perhaps, you can also see that between 2002 and 2007, credit enhancement levels declined rather consistently, falling to 12.1 per cent by 2007.

That decline did not go unnoticed by markets, which reacted accordingly, according to S&P: Interestingly, the market reacted to declining credit enhancement levels by credit tranching the ‘AAA’ portion of transactions into senior tranches with 20% credit enhancement and junior tranches with lower levels of credit enhancement. The first transaction to employ that structure was CSFB 04 C4, which priced on Oct. 27, 2004 (7).

It was only a few months later, in early May 2005, that the market went a step further by starting to divide the tranches with 20% enhancement into “super duper” tranches with 30% credit enhancement and mezzanine tranches at the ‘AAA’ level with 20% credit enhancement.

The first transaction to display such a structure was WBCMT 05 C18 (8), which had three layers with ‘AAA’ ratings:

  • (i) six “super-duper senior” tranches with 30% credit enhancement;
  • (ii) one “super senior” tranche with 20%; and (iii) one “senior” tranche with roughly 13.7%.

Today, the “super seniors” are generally called “AM” classes (”M” for mezzanine) and the “seniors” are called “AJ” classes (”J” for junior). The top tranches are still called “super dupers”.

Fast forward to June 2009 — when markets are reacting to the new proposed S&P methodology and potential downgrades.

From the FT:

Braced for such downgrades, investment banks have been repackaging existing bonds in the past week to add credit enhancement.

This trend could accelerate, analysts said.

CMBS links

CMAlert.com statistics from the newsletter for the commercial estate industry

See also

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