Performance of CMBS Specialty Serviced Assets Deteriorates

Analysts' expectations are painting a worrisome picture for the performance of securitized specialty serviced commercial mortgage loans.

Credit deterioration fueled a downgrade spree of CMBS assets.

Fitch Ratings has downgraded various pools of commercial mortgage pass-through certificates from Merrill Lynch Mortgage, Morgan Stanley and JPMorgan Commercial Mortgage, due to millions in losses incurred or projected.

Fitch downgraded and assigned a recovery rating to class J of Morgan Stanley Capital I Inc. series 1997-HF1 placing $1.3 million class J to D/RR6 from CCC resulting from losses incurred from loan liquidations. As of February, the pool's collateral balance has been reduced 99.8% from $618.4 million at issuance to $1.2 million.

The agency downgraded and assigned Merrill's series 2003-KEY1 loss severity ratings and recovery ratings to a number of classes mostly "due to an increase in expected losses on specialty serviced assets," the agency said.

For example, as of the February 2010 distribution date, the pool's certificate balance paid down 10% to $969 million compared to $1.07 billion at issuance as of the three specialty serviced loans in the pool two are delinquent and one is performing matured.

Over $100 million of Bank of America's series 2004-4 commercial mortgage pass-through certificates also downgraded from rating watch to loss severity ratings or recovery ratings.

Similarly, various JPMorgan Commercial Mortgage series 2004-C1 classes received loss severity ratings, again due to projected losses on specialty-serviced assets, Fitch said.

A recent Barclays Capital U.S. CMBS strategy report also warned things may get worse before they get better. In their initial March remittance update analysts stress that the credit performance side suggests an increase in the pace of credit deterioration. If the 30-plus-day delinquency surged by 90 basis points in March to 7.8% "across the fixed-rate universe," the rate jumps to 11.2% if specialty serviced current loans are added to the metric.

It is, however, important to note that given the large size of commercial loans, it takes one loan to skew delinquency rates. One such loan is the $3 billion Peter Cooper Village and Stuyvesant Town loan, which transferred from current with the special servicer to foreclosure.

Meanwhile, there is some divergence among pre-2005 vintages. Their March 30-plus-day delinquency rate remained steady at 6.1% compared to a 124 bp increase in the rate among 2005 and after vintages to 8.4%, a trend analysts expect to continue.

Barclays analysts Aaron Bryson and Tee Yong Chew note that the commercial mortgage-backed securities rally continues "its torrid pace" as the estimated cash flow for super seniors was an additional 20-30 bps tighter. "At the senior AAA level, we see fundamental long-term value but remain concerned that current spread levels do not adequately compensate for the excessive volatility of the sector. On the subordinate side we remain negative given a faster-than-expected increase in the pace of credit deterioration in recent months."

Going forward, the Barclays analysts remain concerned these developments "may cause delinquency metrics to turn from less of a lagging indicator of fundamentals to more of a leading indicator."

More specifically due to the transfer of several high-profile large loans in recent vintages transfer to the special servicer with modification requests, which may be followed by other borrowers in similar situations, the report notes.

"This will lead to larger fees for special servicers, a faster ramp in interest shortfalls, and greater uncertainty about bond-level cash flows across the capital structure."