Ninefold Jump in Commercial IOs

Interest-only loans have jumped to about 66% of all commercial mortgage-backed securities loans rated by Moody's Investors Service in the second quarter, up from their 56% share during the first quarter and 7% share for the first quarter of 2003.

Moody's also reports that leverage on CMBS loans has gone up to 100.5% during the second quarter, the first time it has exceeded 100%.

Of the second quarter IO loans, about 60% were IO for a part of their term, while 40% were IO for their entire term.

The credit rating agency is concerned about this trend, which "creates a credit issue for investors."

Sally Gordon, a Moody's analyst, said, "The issue for investors is that CMBS pools with more IO loans inherently have less margin for error to allow for underperformance in the supporting collateral."

This is because IO loans have little or no amortization, which would normally reduce the principal balance of the loan as it pays down.

Also, at the time of refinancing, borrowers could face problems if interest rates are higher, impeding their ability to refinance.

Moody's therefore sees the possibility of balloon default.

"Limited or no equity buildup through amortization means the amount to be refinanced at the end of the loan's term is the same, or nearly the same, as at the initial loan date," Ms. Gordon notes.

The rating agency believes that this increase in IO loans could impact CMBS performance for several years to come.

Deals with a large share of IO loans will have less credit support and therefore less margin for error should the collateral underperform.

The benefit for borrowers is that as the prices of commercial real estate properties have gone up, IO loans allow buyers to pay the higher prices since loan payments without the principal component keep their monthly payments low.

Moody's also reports in its second-quarter CMBS update that along with increased issuance of CMBS, which was over $72 billion for the first half of the year, another key credit metric has weakened.

Leverage on conduit loans has gone up from 95.2% during the first quarter of the year to 100.5% during the second quarter.

Tad Philipp, Moody's managing director, CMBS, said, "This marks the first time that the average conduit loan leverage has exceeded 100%, as well as the sharpest quarter-to-quarter increase in leverage yet. Moody's has been raising subordination levels in response to recent increases in leverage."

Mitigating these concerns of Moody's are "generally positive" commercial real estate fundamentals, although performance varies from market to market.

In the second quarter, Moody's rated 55 CMBS transactions with 622 tranches, affirming 393 tranches, upgrading 198 and downgrading 31.

The rating agency reports that upgrades outpaced downgrades across all transaction types.

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