Fitch: US CMBS Loss Severity to Rise Markedly Next Year

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Fitch: US CMBS Loss Severity to Rise Markedly Next Year
Fitch believes the higher volume of resolutions and high recoveries in 2008 belie the current condition of the commercial real estate market.


With US CMBS servicers needing more time to resolve delinquent loans combined with market value declines, loss severities are expected to rise markedly for US CMBS next year and well into 2010, according to Fitch Ratings.

More than three-fourths (78%) of loan resolutions resulted in no losses to the trust last year.

But with commercial real estate debt capital remaining scarce, disposition times will increase to between 24 and 36 months as special servicers are contending with a record backlog of loans (up over 300% since beginning of the year).

‘Special servicers may have to hold certain properties until liquidity returns to the market,’ said Senior Director Britt Johnson. ‘Though recent REMIC reforms may help mitigate loss severities, defaulted loans will take more time to be resolved and losses often will be deferred until maturity.’

Multifamily loans represented an average cumulative loss severity of 38.6% in 2008, with that number likely to increase as many markets have seen increasing levels of unemployment and are suffering from oversupply. Other property types that will see increased loss severities include office (33.3% cumulative average loss in 2008) and hotels (39.5% last year). It should be noted that other property types other than multifamily collectively make up a significantly smaller piece of the CMBS loan universe.

That being said, another area that Fitch is increasingly concerned with of late is hotel loans (39.5% cumulative average loss in 2008). ‘Additional hotel losses and defaults are likely as sponsors may deplete reserves or discontinue coming out of pocket to pay debt service on underperforming assets,’ said Johnson.

AGA7d

Given the precedent of GGP, how the CMBS debacle plays out is still fuzzy. Yes, there will be lots of default - but what can CMBS holders do? So far, very few properties have been liquidated given the poor market condition. So likely they are stuck for a while.

This article tells more story on the CMBS paper holders.

The invisible cost of avoiding defaults

    * Story by: John Dizard
    * Magazine: FTfm
    * Published Tuesday , October 20, 2009

The firing squad in front of commercial mortgage backed bonds is taking yet another cigarette break.

There was a sharp increase in the demand for this paper last month, with prices rising despite more television coverage of politicians' warnings of the risk to banks from bad commercial real estate loans.

Despite all the reports about empty buildings, falling rents, etc, etc, the buy side has been loading the boat with cheap commercial mortgage paper.

There were two reasons for this: the enormous inflows of cash into bond funds and portfolios have already bid up all the sound paper, or even junk corporates, and the fetid CRE paper was what was left.

Then the Federal government made it easier to do orderly, if not necessarily wise, workouts of real estate loans.

The banks, in any event, are not the principal holders of the "investment grade" CMBS paper.

About half of that is held by insurance companies, with much of the rest in the perspiring hands of the sovereign wealth funds, and others who once believed the ratings agencies.

The people who bought those bonds, or, in many cases, their successors, have been in a struggle with the holders of the "B piece", or subordinated, debt over whether troubled properties should be declared in default or not.

The sub debt people, who in many cases include the servicers, or day-to-day managers of the underlying loans and payments on the securities, want to defer the loan maturities for troubled properties, at least notionally in the hope that the markets for commercial property will improve.

The senior debt holders, who may have not only the now virtually valueless equity, but the subordinated debt that can be written down before they suffer, often have an economic interest in declaring default and selling the property immediately to get their capital back.

However, while their senior secured position gives them first claim on the assets, they do not get to take the lead on ordering restructurings. That power goes to the senior-most impaired class, which will be one of the subordinated debt tranches.

In other words, the triple A people may have the strongest claim, but have a hard time exercising it. Unless there is a declared default.

This has led to "tranche warfare" between the two classes, in the form of tedious exchanges between real estate and bankruptcy lawyers.

On 15 September, though, the senior bondholders lost a major battle.

The US Treasury and its Internal Revenue Service issued a ruling that effectively made it easier for the servicers of REMICs, a legal structure used by commercial mortgage loan securitisers, to restructure the loans without losing the REMICs’ favoured tax status.

As one lawyer who has fought on both sides of the tranche wars, says: "This will give borrowers [the developers and equity owners] more flexibility to approach the servicers and get loans modified before they are in imminent danger of default. That allows them more time to turn the properties around."

It also gave an instant windfall to the holders of i/os, or securities that are strips of interest payments on the subordinated mortgage debt.

The prices of the i/os shot up on the ruling, since now even mortgages on many properties worth far less than their outstanding debt will continue to make those interest payments, even though the principal payments will be deferred.

Through a happy coincidence the i/o holders are often also the special servicers. And with more easily restructured properties, the special servicers are more likely to continue to receive the income from the servicing charges. So for them, the holidays came early.

Their interests happened to coincide with those of the US administration and Congress, who like the idea of kicking the can of loss recognition down the road, past at least the next couple of elections.

I am not picking on the Democrats here; the overleveraging of commercial real estate reached its absurd peak on the Bush administration's watch.

While there is a lot to be said for avoiding litigious solutions to the problem of commercial real estate, the seemingly hard-hearted senior lenders, and the other liquidationists, can make a good case for the general social value of declaring defaults, selling troubled properties at fire sale prices, and taking an enema for the whole lump of undigested construction materials.

Essentially, by never taking economically justified writedowns, the US economy will be jellied into low growth, like 1990s Japan but with junkier cars and without the fresh sushi.

As a liquidationist banker puts it: "Without recognising the losses and writing off the bad loans, you will not get price discovery. So prospective new capital will not find out what the property is worth, and, therefore, not be attracted to get the real estate market going again."

It is not just faceless foreigners and insurance executives who will lose out. The US will not get new construction jobs, mobility for its workforce and companies, or tax revenues from new activity. But those are all invisible opportunity costs. The visible losses would be here and now.