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Commercial mortgage-backed securities

Commercial mortgage-backed securities (CMBS) are created by pooling income-producing real estate such as apartments, warehouses, office buildings, hotels, etc.

They carry significant credit risk particularly in countries, such as the US, where they are non-recourse loans. It means that the lender cannot recover any deficit between property value and loan amount in the even to default from the borrower.

Credit analysis of CMBS

Two important indicators used in the credit analysis of CMBS are the loan-to-value ratio (LTV) and debt service coverage (DSC) ratio. The debt service coverage ratio is the ratio of net operating income (NOI) of the property divided by the debt service charge. NOI equals cash income minus cash expenses minus a replacement charge for depreciation and debt service charge is the sum of interest payment and principal repayment. A low LTV and a high DSC ratios are better.

CMBS risk management

A CMBS employs credit enhancement such as subordination to obtain the desired credit rating for the senior tranches. While the interest payments are credited to all tranches, any principal defaults are borne by the lowest-priority tranche (also called the first-loss piece, residual tranche or equity tranche) which is often unrated.

CMBSs typically also contain call protection and balloon maturity provision.

Call protection

While RMBSs have significant prepayment risk, CMBSs have call protection and this is why they trade more like a bond. The call protection comes either at the structure level or loan level.

At the structure level, the tranches are sequential by the order of credit rating, a better-rated tranche is paid first and so on.

At the loan level, four mechanisms are used to offer call protection to investors:

  • Prepayment lockout period, a period in which no prepayment can be made,
  • Prepayment penalty points, a certain percentages of the principal is charged as penalty for prepayment,
  • Yield maintenance charge (also called make-whole provision), requiring borrower to bridge the gap between contract rates and current rates; and
  • Defeasance, in which the borrower use the prepayment amount to purchase government securities sufficient to meet the scheduled principal prepayment, as and when they become due.

Balloon maturity provision

Many CMBSs have balloon maturity, a large principal repayment at the end of the loan. If the borrower defaults on the balloon payment, the lender may extend the loan over the workout period by charging a higher rate called default interest rate. This results in additional risk for investors called balloon risk, which is a type of extension risk.

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