CH-13-14 Nonagency Residential Mortgage-Backed Securities – Bond Markets, Analysis and Strategies : Book Guide

This Document Contains Chapters 13 to 14 CHAPTER 13 NONAGENCY RESIDENTIAL MORTGAGE-BACKED SECURITIES CHAPTER SUMMARY In this chapter, we discuss the nonagency RMBS market, focusing on the structure of the securities created, particularly on credit enhancement. We will describe the different forms of credit enhancement in this chapter. The difference between private label RMBS and subprime RMBS is due to the complexity of the structure for dealing with credit enhancement required because of the greater credit risk associated with subprime mortgage loans. COLLATERALIZED TYPES Conforming mortgages are typically collateral for agency RMBS while nonconforming mortgages are for nonagency RMBS. The collateral backing a nonagency RMBS is set forth in the prospectus as illustrated in an actual deal. Typically a deal will be backed by a combination of collateral types. Prime loans are loans to borrowers viewed as having (1) a high credit quality as gauged by strong employment and credit histories, and income sufficient to pay the loan obligation without jeopardizing the borrower’s creditworthiness, and (2) substantial equity in the underlying property. Subprime loans are loans to borrowers viewed as having (1) lower credit quality or (2) loans that are not a first lien on the property. One type of adjustable-rate mortgage (ARM) loan that was popular during the period between 2001 and 2007 was hybrid ARM loans, also referred to as option ARM loans. This product allowed borrowers to be able to qualify for a loan where they otherwise would not be able to do so using traditional mortgage loans. The reason why these loans are referred to as “option” ARM loans is that the borrower has the option to select among payment options. CREDIT ENHANCEMENT Because there is no government guarantee or guarantee by a GSE, to receive an investment-grade rating, these securities must be structured with additional credit support. The credit support is needed to absorb expected losses from the underlying loan pool due to defaults. This additional credit support is referred to as a credit enhancement. There are different forms of credit enhancement. When rating agencies assign a rating to the bond classes in a nonagency MBS, they look at the credit risk associated with a bond class. Basically, that analysis begins by looking at the credit quality of the underlying pool of loans. Given the credit quality of the borrowers in the pool and other factors such as the structure of the transaction, a rating agency will determine the dollar amount of the credit enhancement needed for a particular bond class to receive a specific credit rating. The process by which the rating agencies determine the amount of credit enhancement needed is referred to as sizing the transaction. There are standard mechanisms for providing credit enhancement in nonagency MBS. When prime loans are securitized, the credit enhancement mechanisms and therefore the structures are not complicated. In contrast, when subprime loans are securitized, the structures are more complex because of the need for greater credit enhancement. There are four forms of credit enhancement. They are senior-subordinated structure, excess spread, overcollateralization, and monoline insurance. Structural Credit Enhancement Structural credit enhancement refers to the redistribution of credit risks among the bond classes comprising the structure in such a way as to provide credit enhancements by one bond class to the other bond classes in the structure. This is achieved by creating bond classes with different priorities on the cash flow and is referred to as a senior-subordinated structure. In a senior-subordinated structure, two general categories of bond classes are created: a senior bond class and subordinated bond classes. Collectively, the bond classes comprising the structure are referred to as the deal’s capital structure. The capital structure here has the same meaning with respect to the prioritization of claims as in a standard corporation’s bond structure. In a corporate bankruptcy under Chapter 11, the priority of creditors is typically violated. However, this is not the case in a nonagency RMBS where the priority rules are strictly enforced for the capital structure. The bond class in the capital structure with the highest rating is referred to as the senior bond class. The subordinated bond classes in the capital structure are those below the senior bond class. The rules for the distribution of the cash flow (interest and principal) among the bond classes as well as how losses are to be distributed are explained in the prospectus. These rules are referred to as the deal’s cash flow waterfall, or simply waterfall. Basically, the losses are distributed based on the position of the bond class in the capital structure. A few points can be noted about the capital structure comprised of bond classes. First, the credit enhancement for bond classes is being provided by other bond classes within the structure. Second, compare what is being done to distribute credit risk in this nonagency RMBS with what is done in an agency collateralized mortgage obligation (CMO). In an agency CMO, there is no credit risk. In contrast, in a nonagency RMBS, there is both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit risk is being redistributed among the bond classes in the structure. Hence, what is being done is credit tranching. Prepayment risk can also be redistributed as is typically done in nonagency RMBS but only at the senior bond class level. Finally, when the bond classes are sold in the market, they are sold at different yields. Most AAA bond classes have been downgraded since 2007. As of year-end 2010, only a small amount of outstanding nonagency RMBS have an investment-grade rating. Shifting Interest Mechanism in a Senior-Subordinated Structure Because of the major credit concerns in subprime RMBS deals and the need to protect the senior bond class, almost all senior-subordinated structures backed by subprime loans incorporate a shifting interest mechanism. This mechanism redirects prepayments disproportionately from the subordinated bond class to the senior bond class according to a specified schedule. The percentage of the mortgage balance of the subordinated bond class to that of the mortgage balance for the entire deal is called the level of subordination or the subordinate interest. The higher the percentage, the greater is the level of protection for the senior bond class. The prospectus will specify how different scheduled principal payments and prepayments will be allocated between the senior bond class and the subordinated bond class. The scheduled principal payments are allocated based on the senior percentage. The senior percentage, also called the senior interest, is defined as the ratio of the balance of the senior bond class to the balance of the entire deal and is equal to 100% minus the subordinate interest. Allocation of the prepayments is based on the senior prepayment percentage (in some deals called the accelerated distribution percentage). This is defined as follows Senior prepayment percentage + Shifting interest percentage × Subordinate interest The “shifting interest percentage” in the formula above is specified in the prospectus. The prospectus will provide the shifting interest percentage schedule for calculating the senior prepayment percentage. The shifting interest percentage schedule given in the prospectus is the “base” schedule. Performance analysis of the collateral is undertaken by the trustee for determining whether to override the base schedule. The performance analysis is in terms of tests, and if the collateral or structure fails any of the tests, this will trigger an override of the base schedule. Deal Step-Down Provisions An important feature in analyzing senior-subordinated bond classes or deals backed by residential mortgages is the deal’s step-down provisions. These provisions allow for the reduction in credit support over time. The provisions that prevent the credit support from stepping down are called “triggers.” Principal payments from the subordinated bond classes are diverted to the senior bond class if a trigger is reached. There are two triggers based on the level of credit performance required to be passed before the credit support can be reduced: a delinquency trigger and a loss trigger. The triggers are expressed in the form of a test that is applied in each period. The delinquency test, in its most common form, prevents any step-down from taking place as long as the current over 60-day delinquency rate exceeds a specified percentage of the then-current pool balance. The principal loss test prevents a step-down from occurring if cumulative losses exceed a certain limit (which changes over time) of the original balance. In addition to triggers based on the performance of the collateral, there is a balance test. This test involves comparing the change in the senior interest from the closing of the deal to the current month. If the senior interest has increased, the balance test is failed, triggering a revision of the base schedule for the allocation of principal pay­ments from the subordinated bond classes to the senior bond class. Originator/Seller-Provided Credit Enhancement The originator/seller of the collateral to the SPV can provide credit support for the transaction in one or a combination of three ways: excess spread, cash collateral and overcollateralization. The most natural form of credit enhancement is the interest from the collateral that is not used to satisfy the liabilities (i.e., the interest payments to the bond classes in the structure) and the fees (such as mortgage servicing and administrative fees). The amount by which the interest payment from the collateral exceeds what has to be paid to the bond classes as interest and the fees that must be paid is called excess spread or excess interest. The monthly excess spread can be either (1) distributed to the seller of the collateral to the SPV, (2) used to pay any losses realized by the collateral for the month, (3) retained by the SPV and accumulated in a reserve account and used to offset not only current losses experienced by the collateral but also future losses, or (4) some combination of the others. In terms of cash collateral, excess spread that we have just described is one of three ways that an originator/seller of the collateral can provide cash to absorb collateral losses. There are two other ways. First is by depositing at the time of the sale of the collateral to the SPV cash that can be utilized if the other forms of credit enhancement are insufficient to meet collateral losses. Second is by providing a subordinated loan to the SPV. Excess collateral is referred to as overcollateralization and can be used to absorb losses. Hence, it is a form of credit enhancement. Overcollateralization is more commonly used as a form of credit enhancement in subprime deals than in prime deals. Third-Party Credit Enhancements Prior to 2007, one form of credit enhancement was some type of third-party credit enhancement. Third-party credit enhancements are subject to third-party credit risk, which is the risk that the third-party guarantor may be either downgraded or not able to satisfy its commitment. Today, few, if any, deals are done with insurance by monoline insurers, bank letters of credit, and related-party guarantees. Risk-based capital requirements have made letters of credit for banks unattractive. Third-party related guarantors are rare because the parent of the originator/seller is typically not triple A rated. CASH FLOW FOR NONAGENCY MORTGAGE-BACKED SECURITIES In agency RMBS, the cash flow is not affected by defaults in the sense that they result in a reduction in the principal to some bond class. Rather, defaulted principal is made up by the agency as part of its guarantee. For a nonagency RMBS, one or more bond classes may be affected by defaults, and therefore, defaults must be taken into account in estimating the cash flow of a bond class. Prior to the subprime mortgage crisis, investors assumed that the triple A senior bonds of nonagency RMBS were exposed to minimal credit risk. The performance of loans backing nonagency RMBS deals demonstrated the critical importance of assessing the factors that impact defaults. What the subprime mortgage crisis clearly showed is that defaults are not just tied to the level of economic activity but also housing prices. Economic difficulties faced by borrowers that followed a period of rising prices provided lenders with a strong position in the collateral as long as the loan-to-value ratio (LTV) was not high. The opportunity to sell the property to repay the loan is not available if the property declines below the outstanding mortgage balance (i.e., the current LTV exceeds 1 or, equivalently, the borrower has negative equity in the property). In such situations, the borrower can exercise the option to put the property to the lender. The reporting of defaults differs for agency RMBS and nonagency RMBS. For agency RMBS, seriously delinquent loans are classified as non-performing loans. These loans are then purchased from the pool’s guarantor at the full amount of the outstanding principal. Any unscheduled principal payment in agency RMBS is treated as part of normal housing turnover. In contrast, the reporting of nonagency RMBS is different. Once a loan moves from the delinquent category to the default category, the borrower loses possession of the property and the mortgage servicer takes possession with the purpose of selling the property. The proceeds received by the servicer reduced by the costs associated with selling the property are referred to as the recovered principal. The servicer must report separately traditional prepayments (which are called voluntary prepayments) and credit-related prepayments (which are called involuntary prepayments). Delinquency Measures A delinquency is requirement before a loan can be classified as in default. Loans are classified as current loans or delinquent loans. A current loan is one in which the borrower has made all mortgage payments due. A delinquent loan is a loan where the borrower fails to make one or more timely payments. At a certain point, a delinquent loan is classified as a defaulted loan. Measuring Default Rates There are two measures used for quantifying default rates for a loan pool: conditional default rate and cumulative default rate. The conditional default rate (CDR) is the annualized value of the unpaid principal balance of newly defaulted loans over the course of a month as a percentage of the unpaid balance of the pool (before scheduled principal payment) at the beginning of the month. The calculation begins with computing the monthly default rate (MDD) for the month as shown below: Monthly default rate for month t MMDt = Then, this is annualized as follows to get the CDR: CDRt = 1 − (1 − default rate for month t)12 The monthly default rate is viewed as representing involuntary prepayments, and the CDR represents the involuntary prepayment speed calculated for non-agency RMBS. The cumulative default rate, abbreviated as CDX, is the proportion of the total face value of loans in the pool that have gone into default as a percentage of the total face value of the pool. Standard Default Rate Assumption A standardized benchmark for default rates was formulated by the Public Securities Association (PSA). The PSA standard default assumption (SDA) benchmark gives the annual default rate for a mortgage pool as a function of the seasoning of the mortgages. As with the PSA prepayment benchmark, multiples of the benchmark are found by multiplying the default rate by the assumed multiple. Prepayment Measures Prepayments are measured in terms of the conditional prepayment rate (CPR). Borrower characteristics and the seasoning process must be kept in mind when trying to assess prepayments for a particular deal. In the prospectus of an offering, a base-case prepayment assumption is made—the initial speed and the amount of time until the collateral is expected to be seasoned. Thus, the prepayment benchmark is issuer specific. The bench­mark speed in the prospectus is called the prospectus prepayment curve (PPC). Slower or faster prepayment speeds are a multiple of the PPC. In nonagency RMBS, two prepayments rates are projected: voluntary prepayment rate and involuntary prepayment rate. The voluntary prepayment rate (VPR) is calculated similarly to a CPR. Involuntary prepayment rates are quoted as CDRs. Deal-Specific Factors Impacting Cash Flow There are deal-specific factors that impact the cash flow of a nonagency RMBS. Two important ones are servicer advances and treatment of modified loans. In a nonagency RMBS deal the servicer has an important function, not only with respect to collecting payments due from borrowers in the loan pool and repossessing and then selling the property when there are defaults, but also in advancing principal and interest on delinquent loans. There are specific conditions as to when a servicer need not make such advance payments. In most deals, the servicer is not required to advance any amount that it deems “nonrecoverable” through the foreclosure process. A modified loan is one in which the terms have been altered in order to help the borrower satisfy the monthly mortgage obligation. The key issue is how servicers treat the modified loans because that impacts the senior and subordinated transactions. APPENDIX SUBPRIME MELTDOWN IN 2007 In the summer of 2007, there was a crisis in the subprime MBS market and this crisis, it has been argued, led to a credit and liquidity crisis that had a rippling impact on other sectors of the credit market as well as the equity market. This episode is referred to as the “subprime meltdown.” In keeping with the history of financial innovation bashing, there have been overreactions, misinformation, and widely differing viewpoints regarding the crisis. Some market observers saw it as the inevitable bursting of the “housing bubble” that had characterized the housing market in prior years. Others viewed it as the product of unsavory practices by mortgage lenders who deceived subprime borrowers into purchasing homes that they could not afford. Moreover, specific mortgage designs such as hybrid loans made it possible for a subprime borrower to obtain a loan that could have been expected to cause financial difficulties in the future when loan rates as part of the loan agreement were adjusted upward. Of course, mortgage lenders blamed borrowers for misleading them. Another contingent laid the blame at the feet of Wall Street bankers who packaged subprime loans into bonds and sold them to investors in the form of MBS. Whatever the precise cause, it’s hard to deny that securitization—the financial framework that allowed Wall Street to package these loans into RMBS—is of enormous benefit to the economy. Securitization has increased the supply of credit to homeowners and reduced the cost of borrowing. It also spreads the risk among a larger pool of investors rather than concentrating it in a small group of banks and thrifts. Securitization is an important and legitimate way for the financial markets to function more efficiently today than in the past. The securitization of subprime loans works by dividing pools of credit into classes, or bond classes, separated by the amount of risk each class represents. Naturally, the classes with less risk offer lower potential returns while the classes with more risk offer higher potential returns. The more junior, riskier classes are purchased by sophisticated institutional investors who understand that they may incur losses but hope for high enough returns over a long period of time to offset possible losses. The demand for this product must come from investors. In the case of RMBS backed by subprime loans, it came ultimately from hedge fund managers. Basically, the major purchasers of subprime MBS were portfolio managers of collateralized debt obligations (CDOs). Managers of CDOs created bond classes that were effectively leveraged positions in a portfolio of RMBS. Hedge fund managers bought the bond classes that were necessary for a transaction to get done. Rating agencies were also viewed by some market observers as being a major contributor to the crisis. Recall that to aid investors in comparing the relative credit risk of securities, issuers generally ask one or more rating agencies to assign a credit rating to the securitization. The accuracy of ratings, like any other indicator of credit risk, can only be assessed on a statistical basis over a long period of time. What is surprising to market observers is why the crisis occurred in July 2007. There was no new information in the market at the time. Investors knew well before that time all about the potential defaults. Moreover, since 2005, the rating agencies took action that was transparent to the market. Specifically, rating agencies adjusted their criteria and assumptions regarding how they were rating subprime MBS transactions, they downgraded some issues, and they publicly commented on their concerns about the subprime sector. The subprime crisis should not be minimized. Some homeowners have suffered from an inability to pay their mortgage. Investors in some RMBS have lost real money. But none of this suggests that securitization created the subprime problem. Instead, securitization has contributed to long-term economic growth by getting credit to the people who really need and can use it. KEY POINTS • Nonagency RMBS are issued by entities such as commercial banks, thrifts, and private conduits. The collateral is sold to a special purpose entity that then issues the securities. • Historically, while nonagency RMBS are classified as private label RMBS and subprime RMBS and traded in separate markets, following the subprime mortgage crisis in 2007 and the meltdown of the housing market, these two sectors are no longer viewed differently. • Although there has been very little issuance since 2008, there is a considerable amount of nonagency RMBS outstanding backed by prime loans, subprime loans, Alt-A loans, second lien loans, and option ARM loans. • Unlike agency RMBS, nonagency RMBS are rated by the nationally recognized rating agencies and require some form of credit enhancement to obtain a credit rating. • The amount of credit enhancement necessary to obtain a particular credit rating is determined by the rating agencies and is referred to as sizing the transaction. • The three forms of credit enhancement are (1) structural (senior-subordinated structure), (2) originator provided (excess spread, cash reserve, overcollateralization), and (3) third-party provided. • The cash flow of a nonagency RMBS depends on defaults and prepayments. • Default rates are measured in terms of the conditional default rate and the cumulative default rate. A standardized benchmark for default rates was formulated by the PSA. The PSA SDA benchmark gives the annual default rate for a mortgage pool as a function of the seasoning of the mortgages. • Voluntary prepayments and involuntary prepayments must be projected in projecting the collateral’s cash flow. • The treatment of advances and modified loans by mortgage services has an impact on the bond classes in a nonagency RMBS deal. ANSWERS TO QUESTIONS FOR CHAPTER 13 (Questions are in bold print followed by answers.) 1. Answer the below questions. a. Why is it necessary for a nonagency mortgage-backed security to have credit enhancement? Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization. Credit enhancement involves the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted. RMBS issued in the nonagency MBS market require that credit enhancement be provided to protect against losses from the loan pool. More details are given below. The nonagency MBS market is divided into the private label MBS market and subprime MBS market. Private label MBS, also referred to as prime or residential deals, are backed by prime mortgage loans; subprime MBS are backed by subprime loans and are commonly classified as part of the asset-backed securities sector and referred to as mortgage-related asset-backed securities. Nonagency MBS are issued by commercial banks, thrifts, and private conduits. Private conduits purchase nonconforming mortgages, pool them, and then sell pass-throughs in which the collateral is the underlying pool of nonconforming mortgages. The private conduits that issue RMBS are doing what the government created the agency conduits to do, without any guarantees (implicit or explicit) from the U.S. government. Nonagency MBS must be registered with the Securities and Exchange Commission. They are rated by the same rating agencies. The amount of credit enhancement necessary to obtain a particular credit rating is determined by the rating agencies and is referred to as sizing the transaction. The four forms of credit enhancement are (1) senior-subordinated structure, (2) excess spread, (3) overcollateralization, and (4) monoline insurance. Common in structures with subprime mortgage loans for senior-subordinated structures is the shifting interest mechanism. The cash flow of a nonagency MBS depends on defaults and prepayments. Default rates are measured in terms of the conditional default rate and the cumulative default rate. A standardized benchmark for default rates was formulated by PSA. We can compare what is being done to distribute credit risk in a nonagency MBS with what is done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae issued structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is viewed until recent years as small. What is being done in creating the different bond classes in an agency CMO is the redistribution of prepayment risk. In contrast, in a nonagency MBS, there is both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit risk is being redistributed among the bond classes in the structure. Hence, what is being done is credit tranching. b. Who determines the amount of credit enhancement needed? Credit enhancement is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization. Credit enhancement is the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted. When rating agencies assign a rating to the bond classes in a nonagency MBS, they look at the credit risk associated with a bond class. Basically, that analysis begins by looking at the credit quality of the underlying pool of loans. For example, a pool of loans can consist of prime borrowers or subprime borrowers. Obviously, one would expect that a pool consisting of prime borrowers would have less expected losses as a percentage of the dollar amount of the loan pool compared to a pool consisting of subprime borrowers. Given the credit quality of the borrowers in the pool and other factors such as the structure of the transaction, a rating agency will determine the dollar amount of the credit enhancement needed for a particular bond class to receive a specific credit rating. The process by which the rating agencies determine the amount of credit enhancement needed is referred to as sizing the transaction. 2. What is the difference between a private label and subprime mortgage-backed security? Be sure to mention how they differ in terms of credit enhancement. The residential mortgage-backed securities (RMBS) market is divided into two sectors: agency MBS and nonagency MBS. RMBS issued in the nonagency MBS market require that credit enhancement be provided to protect against losses from the loan pool. The nonagency MBS market is divided into the private label MBS market and subprime MBS market. The difference between private label MBS and subprime MBS is due to the complexity of the structure for dealing with credit enhancement required because of the greater credit risk associated with subprime mortgage loans. Private label MBS, also referred to as prime or residential deals, are backed by prime mortgage loans; subprime MBS are backed by subprime loans and are commonly classified as part of the asset-backed securities sector and referred to as mortgage-related asset-backed securities. 3. Answer the below questions. a. What is an option ARM loan? A type of adjustable-rate mortgage (ARM) loans popular during the period between 2001 and 2007 (when ARM issuance reached its peak) was hybrid ARM loans, also referred to as option ARM loans. This product allowed borrowers to be able to qualify for a loan where they otherwise would not be able to do so using traditional mortgage loans. In this loan arrangement, the loan rate is fixed for a contractually specified number of years (three, five to seven, and 10 years). At the end of the initial fixed-rate period, the loan resets in a fashion very similar to that of more traditional ARM loans. The reason why these loans are referred to as “option” ARM loans is that the borrower has the option to select among payment options. b. Why is it unlikely that this loan type will be originated in the future? The 2007 subprime mortgage crisis, it is not likely that this loan type will continue due to the risks that were brought out with this crisis. This is explained below. While the flexibility built into option ARM loans come with risks. First, investors can not increase their equity unless the make the larger amortizing payments. Most investors choose smaller payments where you end of owing more at the end of each month. Thus, the option ARM loan becomes a negative amortization loan. Additionally, the smaller payments do not continue. Eventually the lending bank will want to put you back on track to pay the loan off and will recast the loan with your “guaranteed minimum payment” increasing sharply making your monthly payment difficult. The end result is that you may have to sell your house in lieu of trying to make monthly house payments you can ill afford. Here lies the major problem: you may have to write a check at closing because your loan balance is greater than the market value of your house. 4. Answer the below questions. a. At one time, prime and subprime RMBS were traded in separate markets. Why? The nonagency RMBS market is divided into the private label RMBS market and subprime RMBS market. Private label RMBS, also referred to as prime or residential deals, are backed by prime mortgage loans; subprime RMBS are backed by subprime loans and prior to 2007 commonly classified as part of the asset-backed securities sector and referred to as mortgage-related asset-backed securities. Due to this (pre-2007) classification, prime and subprime RBS were traded in separate markets. b. Why after 2007 are prime and subprime RMBS treated as one asset type? Prior to the crisis that occurred in the subprime mortgage market that began in the summer of 2007 and the subsequent housing market meltdown, private label RMBS and subprime RMBS were viewed as two distinct products and traded in separate markets. However, due to the poor performance of the underlying residential mortgage loans backing both types of nonagency RMBS, the post-2007 market no longer makes a distinction between these two products. Thus, prime and subprime RBS are treated as one asset type. 5. Answer the below questions. a. What is meant by a senior-subordinated structure? A senior-subordinated structure refers to a structure that is created with two general categories of bond classes: a senior bond class and subordinated bond classes. b. Why is the senior-subordinated structure a form of credit enhancement? Credit enhancement is the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted. A senior-subordinated structure is a form of credit enhancement because it serves to control credit risk in a manner that is satisfactory to the lender. A senior-subordinated structure creates credit enhancement for bond classes that are provided for by other bond classes within the structure. For example, the senior bond class is being protected against losses by the subordinated bond class. We can compare what is being done to distribute credit risk in a nonagency MBS with what is done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae issued structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is viewed until recent years as small. What is being done in creating the different bond classes in an agency CMO is the redistribution of prepayment risk. In contrast, in a nonagency MBS, there is both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit risk is being redistributed among the bond classes in the structure. Hence, what is being done is credit tranching. Can prepayment risk also be redistributed? This is typically done in nonagency MBS but only at the senior bond class level. That is, the senior bond classes in a nonagency CMO structure can be carved up to create senior bond classes with different exposure to prepayment risk. 6. How can excess spread be a form of credit enhancement? Credit enhancement is the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted. Excess spread, also referred to as excess interest, is basically the interest from the collateral that is not being used to satisfy the liabilities (i.e., the interest payments to the bond classes in the structure) and the fees (such as mortgage servicing and administrative fees). The excess spread can be used to realize any losses. If the excess spread is retained in the structure rather than paid out, it can be accumulated in a reserve account and used to pay not only current losses experienced by the collateral but also future losses. Hence, excess spread is a form of credit enhancement. Because the loan rate on subprime loans is greater than the loan rate on prime loans and because the expected losses are greater for subprime loans, excess spread is an important source of credit enhancement for subprime MBS. 7. Answer the below questions. a. What is the difference between credit tranching and prepayment tranching? Credit tranching refers to redistributing credit risk among bond classes in the structure, while prepayment tranching refers to redistributing prepayment risk among bond classes. b. Why would there be both types of tranching in a nonagency deal but only one type of tranching in an agency deal? Consider the distribution of credit risk in a nonagency MBS with what is done in an agency CMO. In an agency CMO, there is no credit risk for Ginnie Mae issued structures and the credit risk of the loan pool for Fannie Mae and Freddie Mac issued structure is viewed until recent years as small. What is being done in creating the different bond classes in an agency CMO is the redistribution of prepayment risk. In contrast, in a nonagency MBS, there is both credit risk and prepayment risk. By creating the senior-subordinated bond classes, credit risk is being redistributed among the bond classes in the structure. Hence, what is being done is credit tranching. Prepayment risk can also be redistributed. This is typically done in nonagency MBS but only at the senior bond class level. That is, the senior bond classes in a nonagency CMO structure can be carved up to create senior bond classes with different exposure to prepayment risk. 8. Answer the below questions. a. What is the conditional default rate? The conditional default rate (CDR) is the annualized value of the unpaid principal bal­ance of newly defaulted loans over the course of a month as a percentage of the unpaid bal­ance of the pool (before scheduled principal payment) at the beginning of the month. The calculation begins with computing the default rate for the month as shown below: Then, this is annualized as follows to get the CDR: CDRt = 1 – (1 – default rate for month t)12 b. What is the cumulative default rate? The cumulative default rate, abbreviated as CDX in order to avoid confusion with CDR, is the proportion of the total face value of loans in the pool that have gone into default as a percentage of the total face value of the pool. 9. Why was the PSA Standard Default curve introduced? A standardized benchmark for default rates was formulated by the Public Securities Association (PSA). The PSA standard default assumption (SDA) benchmark gives the annual default rate for a mortgage pool as a function of the seasoning of the mortgages. As with the PSA prepayment benchmark, multiples of the benchmark are found by multiplying the default rate by the assumed multiple. Prepayments are measured in terms of the conditional prepayment rate (CPR). Borrower characteristics and the seasoning process must be kept in mind when trying to assess prepayments for a particular deal. In the prospectus of an offering, a base-case prepayment assumption is made—the initial speed and the amount of time until the collateral is expected to be seasoned. Thus, the prepayment benchmark is issuer specific. The benchmark speed in the prospectus is called the prospectus prepayment curve (PPC). Slower or faster prepayment speeds are a multiple of the PPC. 10. Why might an interest rate derivative such as an interest rate swap or interest rate cap be used in a securitization transaction for residential mortgage loans? Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. There are standard mechanisms for providing credit enhancement in nonagency MBS. When prime loans are securitized, the credit enhancement mechanisms and therefore the structures are not complicated. In contrast, when subprime loans are securitized, the structures are more complex because of the need for greater credit enhancement. Since these more complex structures are found in certain types of asset-backed securities (ABS), this is the reason why market participants classify securitization involving subprime loans as part of the ABS market (recall that they are referred to as mortgage-related ABS). There are often interest rate derivatives such as interest rate swaps and interest rate caps employed in nonagency MBS structures that are not allowed in agency MBS structures. We can point out that they are used when there is a mismatch between the character of the cash flows for the loan pool and the character of the cash payments that must be made to the bond classes. For example, some or all of the bonds classes may have a floating interest rate, whereas all the loans have a fixed interest rate. 11. Why is a shifting interest mechanism included in a securitization where the collateral is residential mortgage loans? Almost all existing senior-subordinated structures backed by residential mortgage loans also incorporate a shifting interest mechanism. This mechanism redirects prepayments disproportionately from the subordinated bond class to the senior bond class according to a specified schedule. The rationale for the shifting interest structure is to have enough subordinated bond classes outstanding to cover future credit losses. More details are given below. The basic credit concern that investors in the senior bond class have is that although the subordinated bond classes provide a certain level of credit protection for the senior bond class at the closing of the deal, the level of protection may deteriorate over time due to prepayments and certain liquidation proceeds. The objective is to distribute these payments of principal such that the credit protection for the senior bond class does not deteriorate over time. The percentage of the mortgage balance of the subordinated bond class to that of the mortgage balance for the entire deal is called the level of subordination or the subordinate interest. As the percentage becomes higher there is a greater level of protection for the senior bond class. The subordinate interest changes after the deal is closed due to prepayments. That is, the subordinate interest shifts (hence the term “shifting interest”). The purpose of a shifting interest mechanism is to allocate prepayments so that the subordinate interest is maintained at an acceptable level to protect the senior bond class. 12. Suppose that for a securitization with a shifting interest mechanism you are given the following information for some month: subordinate interest = 25% shifting interest percentage = 85% regularly scheduled principal payment = $3,000,000 prepayments = $1,200,000 a. What is the senior prepayment percentage for the month? The senior percentage, also called the senior interest, is defined as the ratio of the balance of the senior bond class to the balance of the entire deal and is equal to 100% minus the subordinate interest, which is given as 25%. Thus, the senior prepayment percentage is: 100% – 25% = 75%. b. How much of the $3,000,000 regularly scheduled principal payment is distributed to the senior class? If the senior percentage is 75% and the scheduled principal payment is $3 million, the senior bond class will get 0.75 × $3,000,000 = $2,250,000 and the subordinated bond class will get $3,000,000 – $2,250,000 = $750,000 (or 0.25 × $3,000,000 = $750,000). c. How much of the $1,200,000 is distributed to the senior class? Allocation of the prepayments of $1,200,000 is based on the senior prepayment percentage (in some deals called the accelerated distribution percentage). This is defined as follows: Senior prepayment percentage + (Shifting interest percentage × Subordinate interest) The “shifting interest percentage” in the formula above is specified in the prospectus. For our problem, the senior interest is 75%, the subordinate interest is 25%, and the shifting interest percentage is 85%. Inserting in our numbers for the above definition give the senior prepayment percentage for the month as: 75% + 0.85 × 25% = 96.25%. If prepayments for the month are $1,200,000 and the senior prepayment percentage for that month (as just computed) is 96.25% or 0.9625, then 0.9625 × $1,200,000 = $1,155,000 is allocated to the senior bond class and $1,200,000 – $1,155,000 = $45,000 to the subordinated bond class. NOTE. The prospectus will provide the shifting interest percentage schedule for calculating the senior prepayment percentage. The shifting interest percentage schedule given in the prospectus is the “base” schedule. The schedule can change over time depending on the performance of the collateral. If the performance is such that the credit protection is deteriorating or may deteriorate, the base shifting interest percentages are overridden and a higher allocation of prepayments is made to the senior bond class. Performance analysis of the collateral is undertaken by the trustee for determining whether to override the base schedule. The performance analysis is in terms of tests, and if the collateral or structure fails any of the tests, this will trigger an over­ride of the base schedule. The tests are described next. While the shifting interest structure is beneficial to the senior bond class holder from a credit standpoint, it does alter the cash flow characteristics of the senior bond class even in the absence of defaults. The size of the subordination also matters. A larger subordinated class redirects a higher proportion of prepayments to the senior bond class, thereby short­ening the average life even further. 13. What is the purpose of the step-down provisions in a securitization? Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. An important feature in analyzing senior-subordinated bond classes or deals backed by residential mortgages is the deal’s step-down provisions in a securitization. The purpose of these provisions is to allow for the reduction in credit support over time. A concern that investors in the senior bond class have is that if the collateral performance is deteriorating, step-down provisions should be altered. The provisions that prevent the credit support from stepping down are called “triggers.” Principal payments from the subordinated bond classes are diverted to the senior bond class if a trigger is reached. There are two triggers based on the level of credit performance required to be passed before the credit support can be reduced: a delinquency trigger and a loss trigger. The triggers are expressed in the form of a test that is applied in each period. In addition to triggers based on the performance of the collateral, there is a balance test. This test involves comparing the change in the senior interest from the closing of the deal to the current month. 14. What is meant by the prospectus prepayment curve? First, we note that repayments are measured in terms of the conditional prepayment rate (CPR). Borrower characteristics and the seasoning process must be kept in mind when trying to assess pre­payments for a particular deal. In the prospectus of an offering, a base-case prepayment assumption is made—the initial speed and the amount of time until the collateral is expected to be seasoned. A unique prepayment benchmark can be developed for an issuer. This benchmark speed in the prospectus is called the prospectus prepayment curve (PPC). Slower or faster prepayment speeds are a multiple of the PPC. In essence, the PPC refers to a multiple of the base case prepayments assumed in the prospectus. The HEP (home equity prepayment) curve is a prepayment scale (ranging from 0% to 100%) for HELs that captures the more rapid plateau for home-equity prepayments vis-a-vis that of traditional mortgages. It is a 10-month seasoning ramp with even step-ups, terminating at the final HEP percentage in the 10th month. The standard HEP is 20%; it equals 2% CPR in the first month, 4% in the second month, 6% in the third month and so on until it levels off at 20% CPR in the 10th month. Sometimes called the pricing prepayment curve, the PPC is a relatively new convention, used mainly with home-equity loans (HELs). It refers to the pricing speed of a transaction as defined in the prospectus and is always issue-specific. Issues are normally priced at 100% PPC, but comparisons among deals can be difficult because PPC may be defined differently in each security’s prospectus. 15. Answer the below questions. a. What is meant by an involuntary prepayment? In regards to the reporting of nonagency RMBS, once a loan moves from the delinquent category to the default category, the borrower loses possession of the property and the mortgage servicer takes possession with the purpose of selling the property. The proceeds received by the servicer reduced by the costs associated with selling the property are referred to as the recovered principal. The servicer must report separately traditional prepayments — which are called voluntary prepayments — and credit-related prepayments — which are called involuntary prepayments. The reason for doing this is for determining the principal payments that must be distributed to the senior bond classes and for determining the losses (i.e., shortfall between the mortgage balance and the recovered principal) that must be allocated to the subordinated bond classes. The monthly default rate is viewed as representing involuntary prepayments, and the CDR represents the involuntary prepayment speed calculated for non-agency RMBS. The cumulative default rate, abbreviated as CDX in order to avoid confusion with CDR, is the proportion of the total face value of loans in the pool that have gone into default as a percentage of the total face value of the pool. b. Why is the distinction between a voluntary and involuntary prepayment important in nonagency RMBS? In nonagency RMBS, two prepayments rates are projected: voluntary prepayment rate and involuntary prepayment rate. The voluntary prepayment rate (VPR) is calculated similarly to a conditional prepayment rate (CPR). First a voluntary monthly mortgage rate, VMM, similar to the single monthly mortality rate (SMM) described in Chapter 11, is calculated. That monthly rate is then annualized to get the VPR. Involuntary prepayment rates are quoted like the conditional default rate (CDR), which is the annualized value of the unpaid principal balance of newly defaulted loans over the course of a month as a percentage of the unpaid balance of the pool (before scheduled principal payment) at the beginning of the month. The SMM for a month for a deal is the sum of the VMM and MDR for that month. 16. When will a mortgage servicer not advance payments for principal and interest? There are specific conditions as to when a servicer need not make such advance payments for principal and interest. In most deals, the servicer is not required to advance any amount that it deems “nonrecoverable” through the foreclosure process. The policy of a servicer regarding how long it will advance against seriously delinquent loans along with the property’s current LTV dictates how it will interpret the term “recoverability”. Because a property’s projected recovered principal depends on its current LTV, servicers typically cease advancing on loans where the current LTV is greater than a specified threshold. 17. Why does the treatment of modified loans in a nonagency RMBS deal impact the bond classes? A modified loan is one in which the terms have been altered in order to help the borrower satisfy the monthly mortgage obligation. Prior to the problems in the market, deal transactions gave the servicer the right to modify a loan but typically did not address how the modification of a loan should be handled. Loan modification programs were established by several government agencies, along with monetary incentives to modify loans with a primary goal being to reduce the monthly mortgage payments of borrowers with proven hardship. This is to be accomplished by a combination of interest rate reduction, term extension, and payment deferral. The key issue is how servicers treat the modified loans because that impacts the senior and subordinated transactions. As an example, consider a loan in a pool where the principal has been modified such that the principal has been deferred. The question is whether such a loan should be written off immediately as a loss and as a result, this would benefit the senior bond classes. On the other hand, if the deferred principal is not recognized until the point where principal losses are realized by the trust, this would result in more interest payments made to the subordinate bond classes that would have had their principal written down. 18. There are some mortgage loans that are balloon loans. This means that when the loan matures, there is a mortgage balance that will require financing. It is the responsibility of the borrower to obtain the refinancing. What is the added risk associated with a pool of loans backed by balloon loans? A balloon loan is a long-term loan, often a mortgage, which has one large payment (the balloon payment) due upon maturity. A balloon loan will often have the advantage of very low interest payments, thus requiring very little capital outlay during the life of the loan. Since most of the repayment is deferred until the end of the payment period, the borrower has substantial flexibility to utilize the available capital during the life of the loan. However, the major problem with such a loan is that the borrower needs to be self-disciplined in preparing for the large single payment, since interim payments are not being made. Given the above description of a balloon loans with a large payment, it stands to reason that a pool of loans backed by balloon loans will pose a greater risk for subordinate or mezzanine certificates. This is because subordinate loans will absorb any short in cash flows that might result from making the balloon payment. 19. Suppose that the loans in the collateral pool for a nonagency RMBS deal have a floating rate. What is the risk associated with issued fixed-rate bond classes? The inclusion of floating-rate mortgage loans in the collateral pool produces floating rate payments. The fixed-rate payments can be difficult to manage when floating rates fall. The risk revolves around the mismatch between the character of the cash flows for the situation where the loans in the collateral pool for a nonagency RMBS deal have a floating rate and the bond classes are fixed rate. The risk can be handled by interest rate derivatives such as interest rate swaps and interest rate caps. While these are often employed in nonagency RMBS structures, they are not allowed in agency RMBS structures. Since we do not cover interest rate derivatives until later chapters, we merely point out for now that they are used when there is a mismatch between the character of the cash flows for the loan pool and the character of the cash payments that must be made to the bond classes. 20. What is the concern with the inclusion of fixed-rate mortgage loans in the collateral pool when the liabilities are floating rate? The inclusion of fixed-rate mortgage loans in the collateral pool locks in fixed rate payments. If these payments become high when floating rates fall, then problems can result in making payments especially to the subordinate bond classes. 21. An interest rate cap allows the buyer of the cap to be compensated if interest rates rise above a reference rate. The buyer has to pay a periodic premium to obtain this protection. When an RMBS transaction has a pool of floating-rate loans, what type of protections does an interest rate cap provide? An interest rate cap provides protection against floating-rates rising above a reference rate by alleviating losses. An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds a certain percentage. Too much of an increase in LIBOR can make securities with fixed payment fall in value. There are interest rate derivatives such as interest rate swaps and interest rate caps employed in nonagency MBS structures that are not allowed in agency MBS structures. These interest rate derivatives can be used when there is a mismatch between the character of the cash flows for the loan pool and the character of the cash payments that must be made to the bond classes. For example, some or all of the bonds classes may have a floating interest rate, whereas all the loans have a fixed interest rate. In our problem, there is not a perfect match due to some involvement with fixed rates. Thus, caps can alleviate this matching problem. CHAPTER 14 COMMERCIAL MORTGAGE LOANS AND COMMERCIAL MORTGAGED-BACKED SECURITIES CHAPTER SUMMARY The mortgage market consists of residential mortgages and commercial mortgages. Residential mortgage loans are for properties with one to four single-family units. Residential mortgage-backed securities are the securities we discussed in the previous two chapters that are backed by residential mortgage loans. In this chapter, we look at commercial mortgages and securities backed by commercial mortgages—commercial mortgage-backed securities (CMBS). COMMERCIAL MORTGAGE LOANS Commercial mortgage loans are for income-producing properties. These properties include multifamily properties, office buildings, industrial properties (including warehouses), shopping centers, hotels, and health care facilities (including senior housing care facilities). Commercial mortgage loans are non-recourse loans. This means that the lender can only look to the income-producing property backing the loan for interest and principal repayment. Indicators of Potential Performance If there is a default on a commercial mortgage loan, the lender looks to the proceeds from the sale of the property for repayment and has no recourse to the borrower for any unpaid balance. Two measures have been found to be key indicators of the potential credit performance: debt-to-service coverage ratio and the loan-to-value ratio. The debt-to-service coverage ratio (DSC ratio) is the ratio of a property’s net operating income (NOI) divided by the debt service. NOI is the rental income reduced by cash operating expenses (adjusted for a replacement reserve). A ratio greater than one indicates that the cash flow from the property is adequate to cover debt servicing. Studies of residential mortgage loans suggest that the key predictor of default is the loan-to-value ratio. For income-producing properties, the value of the property is based on the principle that the value of an asset is the present value of the expected cash flow. In valuing commercial property, the expected cash flows are the future NOIs. A discount rate or “capitalization rate,” reflecting the risks associated with the cash flows, is used to compute the present value of the future NOIs. Call Protection For residential mortgage loans, only prepayment penalty mortgages supply protection against prepayments. For commercial mortgage loans, call protection includes prepayment lockout, defeasance, prepayment penalty points, and yield maintenance charges. A prepayment lockout is a contractual agreement that excludes any prepayments during the lockout period. After the lockout period, call protection usually comes in the form of either prepayment penalty points or yield maintenance charges. With defeasance, the borrower provides ample funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments. Prepayment penalty points are predetermined penalties that must be paid by the borrower if the borrower wishes to refinance. Prepayment penalty points are not always an effective means for discouraging refinancing. Yield maintenance charge makes the lender indifferent as to the timing of prepayments. The simplest and most restrictive form of yield maintenance charge (“Treasury flat yield maintenance”) penalizes the borrower based on the difference between the mortgage coupon and the prevailing Treasury rate. Balloon Maturity Provisions Commercial mortgage loans are typically balloon loans requiring sizeable principal payment at the end of the balloon term. If the borrower fails to make the balloon payment, the borrower is in default. During the work-out period for the loan, the borrower is charged a higher interest rate, which is called the default interest rate. The risk that a borrower will not make the balloon payment is called balloon risk or extension risk. COMMERCIAL MORTGAGE-BACKED SECURITIES Many types of commercial loans can be sold by the originator as a commercial whole loan or structured into a commercial mortgage-backed security (CMBS) transaction. A CMBS is a security backed by one or more commercial mortgage loans. The whole loan market, which is largely dominated by insurance companies and banks, is focused on loans between $10 and $50 million issued on traditional property types (multifamily, retail, office, and industrial). CMBS transactions, on the other hand, can involve loans of virtually any size and/or property type. Issuers of Commercial Mortgage-Backed Securities As with residential mortgage-backed securities (RMBS), CMBS can be issued by Ginnie Mae, Fannie Mae, Freddie Mac, and private entities. All of the securities issued by Ginnie Mae, Fannie Mae, and Freddie Mac are consistent with their mission of providing funding for residential housing. While securities backed by Ginnie Mae and issued by the two government-sponsored enterprises constitute the largest sector of the RMBS market, it is the securities issued by private entities that are by far the largest sector of the CMBS market. Typically, it is less than 3% of the market. Our focus in this chapter is on CMBS issued by private entities. How CMBS Trade in the Market One might think that because CMBS and RMBS are backed by mortgage loans, they would trade in a similar manner in the marketplace. That is not the case, and the primary reason has to do with the greater prepayment protection afforded to investors in CMBS compared to RMBS. CMBS trade much like corporate bonds. Differences Between CMBS and Nonagency RMBS Structuring The structure of a CMBS transaction is the same as in a nonagency RMBS in that most structures have multiple bond classes (tranches) with different ratings, and there are rules for the distribution of interest and principal to the bond classes. However, there are three major differences due to the features of the underlying loans. The first difference in structuring involves the fact that the prepayment terms for commercial mortgages differ significantly from residential mortgages. CMBS transactions impose prepayment penalties or restrictions on prepayments. While there are RMBS transactions with prepayment penalties, they are a small fraction of the market. The second difference in structuring is due to the significant difference between commercial and residential mortgages with respect to the role of the servicer when there is a default. In commercial mortgages, the loan can be transferred by the servicer to the special servicer when the borrower is in default, imminent default, or in violation of covenants. There is no equivalent feature for a residential mortgage in the case of an imminent default. There can be differences in loans as to how to deal with defaults due to a failure to meet the balloon payment. While balloon risk must be taken into account in structuring a CMBS transaction, it is not something that has to be dealt with in structuring an RMBS. The third difference in structuring between CMBS and RMBS has to do with the role of the buyers when the structure is being created so as to remove certain loans from the pool. More specifically, typically potential buyers of the junior bond classes are first sought by the issuer before the deal is structured. The potential buyers first review the proposed pool of mortgage loans and in the review process may, depending on market demand for CMBS product, request the removal of some loans from the pool. Structural Features of a CMBS Transaction To understand the features of a CMBS transaction, one can look at an actual deal. In doing this, one can observe the issue date, the number of tranches in the deal, the details (such as ratings and coupon rates) for all tranches, the distributions of interest and principal from the supplementary prospectus, and so forth. When there are mortgage loan losses, they are allocated in ascending order to the bond classes. Class X is an interest-only security, no principal payments or loan losses are allocated to that class. However, the notional amount for Class X is reduced by principal payments or loan losses. The credit enhancements for nonagency RMBS can be used in CMBS structures. Typically, the primary form of credit support is the senior-subordinated structure. Prepayment Protection and Distributions of Prepayment Premiums In a CMBS structure, there are two levels of prepayment protection. The first is at the loan level. There are various forms of prepayment protection provided (lockouts, prepayment penalty points, yield maintenance, and defeasance). The second is at the structure level. For example, the senior tranches can be structured to pay off sequentially as in a CMO structure. When a defeasance occurs, there is no distribution made to the bondholders. Since there are no penalties or charges, there is no issue as to how any penalties paid by the borrower are to be distributed among the bondholders in a CMBS structure. When there are prepayment penalty points, there are rules for distributing the penalty among the CMBS bondholders. In the case of loans with a yield maintenance provision, several methods are used for distributing the yield maintenance charge. Depending on the method specified in a deal, not all bondholders in a CMBS may be made whole. Prepayment penalties and yield maintenance charges are referred to as prepayment premiums. Balloon Risk in CMBS Deals CMBS with senior subordinated structures face the risk that all loans must be refinanced to pay off the most senior bondholders. The balloon risk of the most senior tranche may be equivalent to that of the most junior bond class in the deal. There are two types of structural provisions that can be present in CMBS transactions to mitigate balloon risk: internal tail and external tail. The internal tail calls for the borrower to document efforts to refinance the loan within one year of the balloon maturity date. With an external tail, the maturity date for the CMBS issue is set to be longer than the balloon payment for the pool of commercial mortgage loans. Clean-up Call Provisions Every CMBS transaction has a clean-up call provision that permits the bond classes that are outstanding to purchase the remaining mortgage loans in a trust. The purpose of clean-up call in all securitizations is to wind-down the transaction when the balance remaining in the transaction is too small to justify the ongoing administrative fees. Typically the cleanup call provision is limited to when the balance of mortgage loans in the mortgage pool represents 1% to 3% of the deal’s original balance of the trust. Usually the price at which the remaining loans can be repurchased is the outstanding balance of the mortgage loans plus accrued interest. TYPE OF DEALS The two major classifications for CMBS deals are single borrower/multi-property deals and multi-property conduit deals. Single Borrower/Multi property Deals In a single borrower/multi-property deal there is one borrower and multiple properties. Three key structural features in such deals are the cross-collateralization feature, cross-default feature, and property release provisions. The cross-collateralization feature is a mechanism whereby the properties that collateralize the individual loans in the mortgage pool are pledged against each loan. The cross-default feature permits the lender to call each loan within the mortgage pool when any one property defaults. By including these two features, the principal and interest payments of all the properties are available to meet the obligations of all the loans. Because there is a single borrower, there is concern that the borrower can benefit by removing the best properties from the mortgage pool by prepaying the balance and selling those properties. This action would result in a deterioration of the structural protection afforded the bondholders. The objective of property release provisions is to protect the investor against borrower removing the best properties from the mortgage pool by prepaying the balance and selling those properties. Two examples of a property release provision are (i) a requirement that if any property is sold, the borrower must retire more than the initial mortgage balance in the pool (say, 125%) and (ii) a sale may not take place if the DSC ratios after a proposed sale are less than prior to the sale. Multi-Borrower Deals The second type of deal is one that involves loans by conduits. Conduits are commercial-lending entities that are established for the sole purpose of generating collateral to securitize, and the CMBS transactions that result are called conduit deals. The rating agencies refer to conduit transactions as multi-borrower deals. When a conduit deal contains one large property for more than $50 million and then smaller loans, it is referred to as a fusion conduit deal. Servicers As with a nonagency RMBS, a servicer is required and plays an important role. The responsibilities of the servicer include collecting monthly loan payments, keeping records relating to payments, maintaining property escrow for taxes and insurance, monitoring the condition of underlying properties, preparing reports for the trustee, and transferring collected funds to the trustee for payment to bondholders. Depending on the transactions, there are several types of servicers. The three most common in CMBS transactions are the sub-servicer, the master servicer, and the special servicer. The sub-servicer collects all payments and gathers property information, which is then sent to the master servicer. The master servicer is responsible for overseeing the deal, verifying that all servicing agreements are being maintained, and facilitating the timely payment of interest and principal. The duties of a special servicer arise only when a loan becomes more than 60 days past due. Typically, the special servicer has the authority to extend the loan, make loan modifications, restructure the loan, or foreclose on the loan and sell the property. Analysis of the Collateral The unique economic characteristics of each income-producing property in a pool backing a CMBS deal require that credit analysis be performed on a loan-by-loan basis not only at the time of issuance, but also be monitored on an on-going basis. The starting point in the analysis is an investigation of the underwriting standards of the originators of the loans in the mortgage pool. For all properties backing a CMBS deal, a weighted-average DSC ratio and a weighted-average LTV is computed. An analysis of the credit quality of a CMBS structure will also look at the dispersion of the DSC and LTV ratios for the underlying loans. In analyzing the collateral, the types of income-producing properties are examined. In general, investors prefer deals that are not concentrated in one property type. Investors are also interested in the geographical dispersion of the properties. The concern is that if the properties were concentrated in one geographical region, investors would be exposed to economic downturns that may be unique to that geographical region. Stress Testing Structures An analysis of the credit quality of the tranches in a CMBS involves looking at the commercial loans on a loan-by-loan basis. Rating agencies and analysts will then stress test the structure with respect to a combination of default and prepayment assumptions. In stress testing default risk, the following three key assumptions are made. The first is the annual rate of defaults as measured by the conditional default rate (CDR). Analysts often assume a CDR of 2% to stress test strong deals and 3% to test weaker deals. A second important assumption is the timing of the defaults. A default can occur sometime early in the term of the loan or at the balloon date (when refinancing is required). A third important assumption is the percentage of the loan balance that will be lost when a default occurs. This measure is called the loss severity. KEY POINTS • Commercial mortgage loans are for income-producing properties. Consequently, the lender looks only to the property to generate sufficient cash flow to repay principal and to pay interest and, if there is a default, the lender looks to the proceeds from the sale of the property for repayment. • Two measures that have been found to be important measures of potential credit performance for a commercial mortgage loan are the debt-to-service coverage ratio and the loan-to-value ratio. • For commercial mortgage loans, call protection can take the following forms: prepayment lockout, defeasance, prepayment penalty points, or yield maintenance charges. • Commercial mortgage loans are typically balloon loans requiring substantial principal payment at the end of the balloon term. If the borrower fails to make the balloon payment, the borrower is in default. Balloon risk, also called extension risk, is the risk that a borrower will not be able to make the balloon payment because either the borrower cannot arrange for refinancing at the balloon payment date or cannot sell the property to generate sufficient funds to pay off the balloon balance. • CMBS are issued by federal agencies (Ginnie Mae, Fannie Mae, or Freddie Mac) and non-agencies. • The structure of a transaction is the same as in a nonagency residential mortgage-backed security, with the typical structure having multiple bond classes with different ratings. • There are rules for the distribution of interest and principal to the bond classes and the distribution of losses. However, there are differences in structuring transactions due to prepayment features, the role of the special servicer in the case of imminent default, and the role of potential investors when the deal is being structured. • In a CMBS structure, there is call protection at the loan level and the structure level. When there are prepayment premiums (i.e., prepayment penalty points or yield maintenance charges), there are rules for distributing the prepayment premiums among the CMBS bondholders. • In a CMBS deal, there are two types of structural provisions that can be present in CMBS transactions to mitigate balloon risk: internal tail and external tail. • A CMBS trades in the market like a corporate bond rather than a nonagency RMBS because of its substantial prepayment protection at the loan and structure level. • There are two major classifications for CMBS deals. One type is the single borrower/multiproperty deal. Three key structural features in these deals are the cross-collateralization feature, cross-default feature, and property release provisions. • The second type of CMBS deal is the multi-borrower deal, also called a conduit deal. A conduit is a commercial-lending entity that is established for the sole purpose of generating collateral to securitize. Depending on the transactions, there are several types of servicers. The three most common in CMBS transactions are the sub-servicer, the master servicer, and the special servicer. • Because of the nonrecourse nature of commercial mortgage loans, investors must view each property as a stand-alone business. The unique economic characteristics of each income-producing property in a pool backing a CMBS deal require that credit analysis be performed on a loan-by-loan basis not only at the time of issuance, but also monitored on an ongoing basis. The starting point is investigating the underwriting standards of the originators of the loans in the mortgage pool. • An analysis of the credit quality of a CMBS structure will also look at the dispersion of the DSC ratios and LTV ratios for the underlying loans, the types of income-producing properties, and the geographical dispersion of the properties. • Rating agencies and analysts will then stress test the structure with respect to a combination of default and prepayment assumptions. • In stress testing default risk, alternative assumptions are made regarding the conditional default rate, the timing of the defaults, and the percentage of the loss severity. ANSWERS TO QUESTIONS FOR CHAPTER 14 (Questions are in bold print followed by answers.) 1. How is the net operating income (NOI) of a commercial property determined? The NOI of a commercial property is determined by taking the rental income and reducing it by cash operating expenses (adjusted for a replacement reserve). In valuing commercial property, the expected cash flows are the future NOIs. A discount rate or “capitalization rate,” reflecting the risks associated with the cash flows, is used to compute the present value of the future NOIs. 2. Why might an investor be skeptical about the loan-to-value ratio for a commercial mortgage loan? The NOI of a commercial property is determined by taking the rental income and reducing it by cash operating expenses (adjusted for a replacement reserve). In valuing commercial property, the expected cash flows are the future NOIs. A discount rate or “capitalization rate,” reflecting the risks associated with the cash flows, is used to compute the present value of the future NOIs. 3. Explain the underlying principle for a yield maintenance charge. The underlying principle for a yield maintenance charge is to prevent lenders from refinancing when it would otherwise be to their advantage. The yield maintenance charge, also called the make whole charge, makes it uneconomical to refinance solely to get a lower mortgage rate. The simplest and most restrictive form of yield maintenance charge (“Treasury flat yield maintenance”) penalizes the borrower based on the difference between the mortgage coupon and the prevailing Treasury rate. 4. What types of prepayment protection provisions result in a prepayment premium being paid if a borrower prepays? For residential mortgage loans, only prepayment penalty mortgages provide protection against prepayments. For commercial mortgage loans, call protection can take the following forms: prepayment lockout, defeasance, prepayment penalty points, and yield maintenance charges. The latter two result in prepayment premium being paid if a borrower prepays. When there are prepayment penalty points, there are rules for distributing the penalty among the CMBS bondholders. Prepayment penalty points are predetermined penalties that must be paid by the borrower if the borrower wishes to refinance. For example, 5-4-3-2-1 is a common prepayment penalty point structure. That is, if the borrower wishes to prepay during the first year, he must pay a 5% penalty for a total of $105 rather than $100; in the second year, a 4% penalty would apply, and so on. It has been argued that the prepayment penalty points are not an effective means for discouraging refinancing. However, prepayment penalty points may be superior to yield maintenance charges in a rising rate environment. This is because prepayments do occur when rates rise. With yield maintenance, the penalty will be zero (unless there is a “yield maintenance floor” that imposes a minimum penalty). In contrast, with prepayment penalty points, there will be a penalty even in a rising rate environment. In the case of loans with a yield maintenance provision, several methods are used in practice for distributing the yield maintenance charge and, depending on the method specified in a deal, not all bondholders in a CMBS may be made whole. The yield maintenance charge makes it uneconomical to refinance solely to get a lower mortgage rate. The simplest and most restrictive form of yield maintenance charge (“Treasury flat yield maintenance”) penalizes the borrower based on the difference between the mortgage coupon and the prevailing Treasury rate. 5. The following statement was made in a special report, “Commercial Mortgage Special Report” (September 19, 2005, p. 2), by Fitch Ratings: “Defeasance of a loan in a CMBS transaction is a positive credit event.” Explain why. The defeasance of a loan in a CMBS transaction is a positive credit event because it can make credit risk of a CMBS disappear. More details are given below. Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed securities 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 “pass-throughs.” Many 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. A defeasance in a CMBS is a provision that voids a bond or loan when the borrower sets aside cash or bonds sufficient enough to service the borrower's debt. By setting aside funds to pay off the bonds, the outstanding debt and cash offset each other on the balance sheet and do not need to be recorded. For example, with defeasance, the borrower provides sufficient funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments. In structuring a CMBS, there are rules for the allocation of any prepayment penalties among the bondholders. In addition, if there is a defeasance, the credit risk of a CMBS virtually disappears because it is then backed by U.S. Treasury securities. In fact, it is because investors like the defeasance feature for commercial mortgages used as collateral for a CMBS that defeasance has become the most popular type of prepayment protection. 6. In an article by Matt Hudgines “More CMBS Borrowers Pay off Balloon Mortgages on Time,” posted on August 18, 2010, the following appeared “Some 49.9% of the securitized loans that matured in July successfully met their balloon payments, according to New York-based Trepp LLC, which closely tracks the commercial mortgage-backed securities (CMBS) market. That’s up more than 11 percentage points from 38.7% the previous month and is the highest level since the end of 2008.” Later in the article, the following appeared: “Until the fourth quarter of 2008, when financial markets experienced a meltdown following the bankruptcy of Lehman Brothers, the monthly average for the number of on-time, paid balloon payments was more than 70%, according to Trepp. Since the beginning of 2009, there hasn’t been a month when even half of the borrowers with CMBS loans reaching maturity were able to make their balloon payments. The average percentage for the past 12 months has been 32.2%.” (See: http://nreionline.com/finance/news/cmbs_borrowers_pay_balloon_mortgages_0818/#) Explain the relevance of this information to investors in CMBS. The increasing percentage of balloon payments made over recent year implies a number of relevant points of interest. Below we mention three of these. Commercial mortgage loans are typically balloon loans requiring substantial principal payment at the end of the balloon term. If the borrower fails to make the balloon payment, the borrower is in default. Thus, a first point of relevance is that fewer borrowers are defaulting. If in default, the lender may extend the loan and in so doing will typically modify the original loan terms. During the work-out period for the loan, a higher interest rate will be charged, the default interest rate. Thus, a second point of relevance is that fewer borrowers are extending their loans with higher interest rates being charged. The risk that a borrower will not be able to make the balloon payment because either the borrower cannot arrange for refinancing at the balloon payment date or cannot sell the property to generate sufficient funds to pay off the balloon balance is called balloon risk. Thus, a third point of relevance is that fewer borrowers are facing balloon risk (e.g., fewer borrowers are faced with worrying about selling property to generate sufficient funds to pay off the balloon balance). 7. Answer the below questions. a. Explain whether you agree or disagree with the following statement: “The largest sector of the CMBS market is securities issued by agency and government-sponsored securities.” One would not agree with the statement. While securities backed by Ginnie Mae and issued by the two government-sponsored enterprises constitute the largest sector of the RMBS market, it is the securities issued by private entities that are by far the largest sector of the CMBS market. Typically, agency and government-sponsored securities are less than 3% of the CMBS market. b. Explain whether you agree or disagree with the following statement: “Most CMBS deals are backed by newly originated commercial mortgage loans.” Commercial mortgage-backed securities (CMBS) are backed by loans secured with commercial rather than residential property. The CMBS market provides liquidity and diversification to commercial real estate investors and ready access to capital for commercial lenders. A commercial mortgage loan is originated either to finance a newly originated commercial purchase or to refinance a prior commercial mortgage obligation. Regardless, the lender needs to look at the cash flow from the property backing payment of the interest and principle. c. Explain whether you agree or disagree with the following statement: “A fusion CMBS deal has only one single large borrower.” Conduits are commercial-lending entities that are established for the sole purpose of generating collateral to securitize, and the CMBS transactions that result are called conduit deals. The rating agencies refer to conduit transactions as multi-borrower deals indicating more than one borrower. When a conduit deal contains one large property for more than $50 million and then smaller loans, it is referred to as a fusion conduit deal. While, a fusion CMBS deal contains one single large borrower, it also has other borrowers. In the deal discussed in the text most, of the loans were originated by one large borrower (or its conduit participants) or were acquired by the one large borrower from various third-party originators. The mortgage loans originated by the one large borrower constituted about three-quarters of the initial mortgage pool. 8. Why do CMBS trade in the market more like corporate bonds than RMBS? One might think that because CMBS and RMBS are backed by mortgage loans, they would trade in a similar manner in the marketplace. That is not the case, and the primary reason has to do with the greater prepayment protection at the loan level afforded to investors in CMBS compared to RMBS. At the structure level (i.e., when the commercial mortgage loans are pooled to create a CMBS), certain tranches can be created that give even greater prepayment protection. As a result, CMBS trade much like corporate bonds. 9. What are the major differences in structuring CMBS and RMBS transactions? The structure of a commercial mortgage-backed security or CMBS transaction is the same (as in a nonagency residential mortgage-backed security or RMBS transaction) in that most structures have multiple bond classes (tranches) with different ratings, and there are rules for the distribution of interest and principal to the bond classes. However, there are three major differences due to the features of the underlying loans. These differences involve the prepayment terms, the role of the servicer when there is a default, and the role of the buyers when the structure is being created. More details are provided below. First, as explained earlier, prepayment terms for commercial mortgages differ significantly from residential mortgages. The former impose prepayment penalties or restrictions on prepayments. While there are residential mortgages with prepayment penalties, they are a small fraction of the market. In structuring a CMBS, there are rules for the allocation of any prepayment penalties among the bondholders. In addition, if there is a defeasance, the credit risk of a CMBS virtually disappears because it is then backed by U.S. Treasury securities. In fact, it is because investors like the defeasance feature for commercial mortgages used as collateral for a CMBS that defeasance has become the most popular type of prepayment protection. The second difference in structuring is due to the significant difference between commercial and residential mortgages with respect to the role of the servicer when there is a default. In commercial mortgages, the loan can be transferred by the servicer to the special servicer when the borrower is in default, imminent default, or in violation of covenants. The key here is that it is transferred when there is an imminent default. The special servicer has the responsibility of modifying the loan terms in the case of an imminent default to reduce the likelihood of default. There is no equivalent feature for a residential mortgage in the case of an imminent default. The particular choice of action that may be taken by the special servicer in a commercial mortgage will generally have different effects on the various bond classes on a CMBS structure. Moreover, there can be a default due to failure to make the balloon payment at the end of the loan term. There can be differences in loans as to how to deal with defaults due to a failure to meet the balloon payment. Thus, balloon risk must be taken into account in structuring a CMBS transaction, which because of the significant size of the payment, can have a considerable impact on the cash flow of the structure. Balloon risk is not something that has to be dealt with in structuring an RMBS. The third difference in structuring between CMBS and RMBS has to do with the role of the buyers when the structure is being created. More specifically, typically potential buyers of the junior bond classes are first sought by the issuer before the deal is structured. The potential buyers first review the proposed pool of mortgage loans and in the review process may, depending on market demand for CMBS product, request the removal of some loans from the pool. This phase in the structuring process, which one does not find in RMBS transactions, provides an additional layer of security for the senior buyers, particularly because some of the buyers of the junior classes have tended to be knowledgeable real estate investors. 10. In a commercial mortgage-backed security, what is the concern that the bondholders have when there is a prepayment premium paid by a borrower? Prepayment penalties and yield maintenance charges are referred to as prepayment premiums. When there are prepayment penalty points, there are rules for distributing the penalty among the CMBS bondholders. In the case of loans with a yield maintenance provision, several methods are used in practice for distributing the yield maintenance charge and, depending on the method specified in a deal, not all bondholders in a CMBS may be made whole. Those less likely to be made whole will be more concerned. Because there is a single borrower, there is concern that the borrower can benefit by removing the best properties from the mortgage pool by prepaying the balance and selling those properties. This action would result in a deterioration of the structural protection afforded the bondholders. The objective of property release provisions is to protect the investor against such an action by the borrower. Two examples of a property release provision are (i) a requirement that if any property is sold, the borrower must retire more than the initial mortgage balance in the pool (say, 125%) and (ii) a sale may not take place if the DSC ratios after a proposed sale are less than prior to the sale. 11. The following appears on the web site of Chatham Financial, an advisory service: “Kennett Square, Pa., June 21, 2010 — Chatham Financial announced today that it advised Primus Capital in the defeasance of $76.9 million in debt secured by twelve properties held in two CMBS securitizations. The defeasance of the loans, which are scheduled to mature in 2018, facilitated the sale of the 12 movie theater properties.” Explain what is meant by a defeasance of loans? Defeasance of a securitized commercial mortgage-backed security (CMBS) is a process by which a borrower substitutes other income-producing collateral for real property to facilitate the elimination of an existing lien without paying-off an existing note. Typically, a basket of U.S treasury obligations is the only collateral suitable for this type of substitution. The original note remains in place after a defeasance, but it is collateralized and serviced by the replaced securities instead of the real estate. These securities can be held by either the original borrower or by a “successor borrower” entity which uses the income from the disposition of the securities to make the monthly interest payments and balloon payment on the mortgage being defeased. The premium a borrower pays to defease is the total cost of buying the securities minus the outstanding loan balance. Payments to CMBS debtholders are not interrupted, and the borrower can sell or place a new first lien on the property. In brief, defeasance removes the need to allocate the prepayment penalty among the various classes of bondholders because the lockout and defeasance provisions prevent the loan from ever being prepaid. Each investor is assured that its bonds will continue to earn interest for the scheduled life of the loan. 12. Explain why commercial mortgage-backed securities do not trade like residential mortgage-backed securities in the market. It is because of the substantial prepayment protection at the loan and structure level that a commercial mortgage-backed security (CMBS) is not viewed in the market in the same way as a nonagency residential mortgage-backed security (RMBS). Rather, CMBS trades in the market like a corporate bond rather than a nonagency RMBS. A commercial mortgage loan is originated either to finance a commercial purchase or to refinance a prior mortgage obligation. Unlike residential mortgage loans, where the lender relies on the ability of the borrower to repay and has recourse to the borrower if the payment terms are not satisfied, commercial mortgage loans are non-recourse loans. This means that the lender can only look to the income-producing property backing the loan for interest and principal repayment. For residential mortgage loans, “value” is either market value or appraised value. For income-producing properties, the value of the property is based on the fundamental principles of valuation: the value of an asset is the present value of the expected cash flow. This makes trading for commercial mortgage loans more risky because it is difficult to estimate future cash flows and discount rates that are needed to arrive at the value of a commercial mortgage loan. 13. Answer the below questions. a. With respect to the mitigation of balloon risk, what is meant by an internal tail? The internal tail is the first of two types of structural provisions that can be present in CMBS transactions to mitigate balloon risk. It requires the borrower to document efforts to refinance the loan within one year of the balloon maturity date. Within six months prior to the balloon maturity date, the borrower must obtain a refinancing commitment. b. With respect to the mitigation of balloon risk, what is meant by an external tail? The external tail is the second of two types of structural provisions that can be present in CMBS transactions to mitigate balloon risk. With an external tail, the maturity date for the CMBS issue is set to be longer than the balloon payment for the pool of commercial mortgage loans. Since this gives the borrower the time to arrange refinancing while avoiding default on the bond obligations, it is the method preferred by rating agencies. 14. Answer the below questions. a. Explain the cross-collateralization feature and its significance in a single borrower / multi-property CMBS transaction. In a single borrower/multi-property deal there is one borrower and multiple properties. Three key structural features in such deals are the cross collateralization feature, cross-default feature, and property release provisions. The cross-collateralization feature is a mechanism whereby the properties that collateralize the individual loans in the mortgage pool are pledged against each loan. Inclusion of this feature (along with the cross-default feature) assures that the principal and interest payments of all the properties are available to meet the obligations of all the loans. b. Explain the cross-default feature and its significance in a single borrower / multi-property CMBS transaction. The cross-default feature permits the lender to call each loan within the mortgage pool when any one property defaults. By including this feature along with the cross-collateralization feature, the principal and interest payments of all the properties are available to meet the obligations of all the loans. As a result, a shortfall on an individual loan would not make it delinquent if the principal and interest payments from other loans in the mortgage pool are not less than the amount of the shortfall. c. Explain the property release provision and its significance in a single borrower / multi-property CMBS transaction. Because there is a single borrower, there is concern that the borrower can benefit by removing the best properties from the mortgage pool by prepaying the balance and selling those properties. This action would result in a deterioration of the structural protection afforded the bondholders. The objective of property release provisions is to protect the investor against such an action by the borrower. Two examples of a property release provision are (i) a requirement that if any property is sold, the borrower must retire more than the initial mortgage balance in the pool (say, 125%) and (ii) a sale may not take place if the DSC ratios after a proposed sale are less than prior to the sale. 15. Answer the below questions. a. How does a single borrower/multi-property deal differ from a conduit deal? In a single borrower/multi-property deal there is one borrower and multiple properties. On the other hand, conduits loans are multi-borrower deals involving commercial mortgage loans that are “originated” in accordance with guidelines that permit them to be rated by credit rating agencies. The mortgages are aggregated into a pool and serve as collateral for publicly traded bonds called “commercial mortgage-backed securities.” In this manner, the mortgages are converted into a commodity that can be “securitized” through the issuance and sale of bonds to investors. Each mortgage portfolio is transferred to a specially created trust and bonds are sold that represent ownership interests in the trust. b. What is meant by a fusion conduit deal? When a conduit deal contains one large property for more than $50 million and then smaller loans, it is referred to as a fusion conduit deal. 16. What are the typical duties of a special servicer? The duties of a special servicer arise only when a loan becomes more than 60 days past due. Typically, the special servicer has the authority to extend the loan, make loan modifications, restructure the loan, or foreclose on the loan and sell the property. 17. How does the analysis of a commercial mortgage-backed security differ from that of a residential mortgage-backed security? A commercial mortgage loan is originated either to finance a commercial purchase or to refinance a prior mortgage obligation. Unlike residential mortgage loans where the lender relies on the ability of the borrower to repay and has recourse to the borrower if the payment terms are not satisfied, commercial mortgage loans are nonrecourse loans. This means that the lender can only look to the income-producing property backing the loan for interest and principal repayment. Thus, the unique economic characteristics of each income-producing property in a pool backing a CMBS deal require that a credit analysis be performed on a loan-by-loan basis. This analysis should not only be performed at the time of issuance, but also monitored on an on-going basis. Finally, the analysis of CMBS should consider three major differences between RMBS and CMBS due to the features of the underlying loans. These differences are described below in detail. First, prepayment terms for commercial mortgages differ significantly from residential mortgages. The former impose prepayment penalties or restrictions on prepayments. While there are residential mortgages with prepayment penalties, they are a small fraction of the market. In structuring a CMBS, there are rules for the allocation of any prepayment penalties among the bondholders. In addition, if there is a defeasance, the credit risk of a CMBS virtually disappears because it is then backed by U.S. Treasury securities. The second difference in structuring is due to the significant difference between commercial and residential mortgages with respect to the role of the servicer when there is a default. In commercial mortgages, the loan can be transferred by the servicer to the special servicer when the borrower is in default, imminent default, or in violation of covenants. The key here is that it is transferred when there is an imminent default. The special servicer has the responsibility of modifying the loan terms in the case of an imminent default to reduce the likelihood of default. There is no equivalent feature for a residential mortgage in the case of an imminent default. The particular choice of action that may be taken by the special servicer in a commercial mortgage will generally have different effects on the various bond classes on a CMBS structure. Moreover, there can be a default due to failure to make the balloon payment at the end of the loan term. There can be differences in loans as to how to deal with defaults due to a failure to meet the balloon payment. Thus, balloon risk must be taken into account in structuring a CMBS transaction, which because of the significant size of the payment, can have a considerable impact on the cash flow of the structure. Balloon risk is not something that has to be dealt with in structuring an RMBS. The third difference in structuring between CMBS and RMBS has to do with the role of the buyers when the structure is being fashioned. More specifically, typically potential buyers of the junior bond classes are first sought after by the issuer before the deal is structured. The potential buyers first evaluate the proposed pool of mortgage loans and in the evaluation process may, depending on market demand for CMBS product, request the elimination of some loans from the pool. This segment in the structuring process, which one does not discover in RMBS transactions, thus providing an additional layer of security for the senior buyers, particularly because some of the buyers of the junior classes have tended to be knowledgeable real estate investors. 18. Why is it not adequate to look at the weighted-average debt-to-service coverage ratio and weighted-average loan-to-value ratio for the pool of commercial mortgage loans in assessing the potential performance of a CMBS transaction? For all properties backing a CMBS deal, a weighted-average DSC ratio and a weighted-average LTV is computed. However, these computations are not adequate in themselves because they do not consider the variation of possible outcomes that can occur. Thus, an analysis of the credit quality of a CMBS structure will also look at the dispersion of the DSC and LTV ratios for the underlying loans. For example, one might look at the percentage of a deal with a DSC ratio below a certain value. 19. Why is it important to look at the dispersion of property types and geographical location of properties in analyzing a CMBS transaction? In general, investors prefer deals that are not concentrated in one property type. Diversifying in a variety of property types reduces risk through avoiding exposure to only one property type. Investors are also interested in the geographical dispersion of the properties. The concern is that if the properties were concentrated in one geographical region, investors would be exposed to economic downturns that may be unique to that geographical region. Because of the non-recourse nature of commercial mortgage loans, investors must view each property as a stand-alone business. The unique economic characteristics of each income-producing property in a pool backing a CMBS deal require that credit analysis be performed on a loan-by-loan basis not only at the time of issuance, but also monitored on an on-going basis. The starting point is investigating the underwriting standards of the originators of the loans in the mortgage pool. An analysis of the credit quality of a CMBS structure will also look at the dispersion of the DSC ratios and LTV ratios for the underlying loans, the types of income-producing properties, and the geographical dispersion of the properties. Solution Manual for Bond Markets, Analysis and Strategies Frank J. Fabozzi 9780132743549, 9780133796773