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CMBS Performance Beats Other Asset Classes

With the economy having taken off and delinquencies on commercial mortgage loans probably already having peaked in the current economic cycle, defaults are probably not uppermost on most servicers' minds right now. The recent downturn has been indeed rather easy on the real estate sector, with real estate emerging as a choice asset class, especially after a host of corporate scandals came into the limelight and investors became more wary of corporate stock and bond investments.

They may be on the right track after all, considering the results of a commercial mortgage backed-securities default study by Fitch Ratings. The study found that corporate bonds had an overall cumulative default rate of about 11% over the period 1990-2003, compared to a cumulative default rate of 0.20% for CMBS over the same period. However, the rating agency expects CMBS default rates to move above these low levels going forward.

The Fitch study was done on a base of 914 CMBS transactions totaling about $484.28 billion, including both investment-grade and speculative classes, rated by any of the three major rating agencies, including Moody's Investors Service and Standard & Poor's. When only the investment-grade-rated bonds were taken into account, the default rate was a mere 0.10%. Taking into account the below investment-grade bonds only, the default rate was a much higher 1.61%. Fitch found that investment-grade defaults totaled $466.9 million while defaults on the speculative grade classes totaled $491.4 million. Also, the investment-grade defaults were found to represent 0.17% of the investment-grade universe by number of classes and 0.10% by dollar amount. And the below-investment-grade defaults represented 1.53% of the below-investment-grade population by number of classes and 1.61% in dollar terms. In another refinement of the study, Fitch found that on removing some "essentially unseasoned" deals of the 2002 and 2003 vintage, representing 28% of the total dollar amount of the CMBS transactions, the default rate on the remaining CMBS deals rose to 0.28%.

Whatever the basis for comparison, the CMBS default rate emerges much lower than the corporate bond default rate. Fitch believes that the "very conservative credit enhancement levels set by rating agencies in the early years of CMBS issuance" are partially responsible for this disparity in the performance of corporate bonds and CMBS. Although CMBS has performed very well so far, Fitch expects that as the asset class matures, defaults are likely to go up. Fitch's analyst trio, Mary O'Rourke, Mary MacNeill and Mary Metz, who have authored this default report, note, "The number of bond defaults in recently issued transactions is of concern, given the default history of more mature transactions. Fitch believes many of the transactions issued in 2002 and 2001 were overweighted with collateral that was aggressively underwritten at the height of the real estate market in 1999 and 2000, relying on unsustainable rent forecasts and optimistic occupancy expectations. Based on the patterns in loan defaults and loss studies, Fitch believes these vintages are both vulnerable to future bond defaults."

The rating agency does not have enough input so far to determine what factors are likely to cause such a rise in future CMBS defaults, considering the low levels of defaults to date, but they expect that "bond default patterns attributable to certain vintages will more clearly emerge over time. "However, Fitch has identified, based on some loan loss studies, some factors that contribute to loss. The rating agency has found that hotel and health care loans "tend to have a higher propensity for defaults and higher loss severities." Loans resolved through a servicer-negotiated discounted payoff have been known to experience the lowest loss severities, while loans remaining in special servicing for longer than 24 months are known to be more likely "to experience a loss severity more than double the average loss for loans settled in less time."

About the conservative credit enhancement levels that were set up for CMBS initially, the analysts explain, "Fitch's CMBS rating model was built upon the default and loss experience of the early 1990s recession, which was more severe than the recent recession and driven largely by a lack of consumer spending.

Credit enhancement levels for CMBS have become "less conservative" in recent years, according to Fitch, which means that below-investment-grade CMBS, especially, are likely to see higher default levels in future.

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