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Are CMBS Delinquencies Too High?

A 172% increase in delinquent loans issued in 2006, plus a weak retail property sector in the second quarter, contributed to the first delinquency increase in commercial mortgage-backed securities since 2003, according to a report by Standard & Poor’s. While the delinquency rate remains nearly unchanged at 0.28%, up one basis point from the previous quarter, future quarters may bring greater declines if analysts’ concerns over recent frothy underwriting prove justified. S&P classifies loans as delinquent at 30 days.

Delinquent loan volume climbed to $1.65 billion in the second quarter, up 12.7% from $1.46 billion in the first quarter, S&P found. Retail loans in delinquency mushroomed to $262 million in the second quarter, up 22% from $214 million in the first quarter, which S&P attributes to declining fundamentals. The retail vacancy rate climbed 10 basis points to 7.3% in the second quarter from the previous quarter, while rent growth slowed to 0.8% from 0.9% in the same period.

The greatest cause for concern in S&P’s report is the rapid increase in delinquencies among loans originated in 2005 and 2006. In the latter vintage, delinquencies shot up to $190.2 million in the second quarter, 172% higher than $69.8 million in the first quarter. Delinquent 2005 loans increased 98% to $258 million in the same period. The two vintages already have more delinquencies than any other vintage except 1998, which had $245.6 million.

“Based on our review of vintage year activity, the industry’s concerns regarding more aggressive underwriting [including higher loans-to-value ratios, lower debt service coverage and interest-only loans] in 2005, and more so in 2006, may already be affecting delinquency numbers,” the report states.

Other rating agencies are worried about the potential for increased defaults in recent conduit loans, too. In April, Moody’s Investors Service increased CMBS subordination levels in its ratings to reflect the increased risk posed by aggressive underwriting. That means CMBS issuers must pay higher yields to bond holders at every level of the CMBS capital stack.

“We do agree that late 2006 and early 2007 was a low watermark for underwriting, and we expect those vintages to have higher delinquencies,” says Tad Philipp, managing director in the commercial mortgage finance group at Moody’s Investors Service.

But is that higher risk of delinquency actually resulting in increased delinquencies, as S&P’s report seems to suggest? Some analysts are skeptical. “We haven’t really seen the evidence of more defaults; our delinquencies have been slowing down,” says Mary MacNeill, managing director of the CMBS group at Fitch Ratings.

Fitch doesn’t consider a loan delinquent until the borrower is 60 days behind on payments, which is one reason the company’s numbers are different from those of S&P, which counts delinquencies of 30 days or more. Fitch’s U.S. CMBS delinquency index fell for the fifth straight month in June to 0.29%, two basis points lower than May’s rate of 0.31%.

Fitch expects aggressive underwriting to affect delinquencies, but not for another year or so. “In past studies we’ve seen that delinquency usually occurs in year three of the loan,” MacNeill says. “If delinquencies usually occur in year three and the loans were originated in 2005, then 2008 is when you’re likely to see a lot of defaults.”

It’s too early to say whether the 2006 vintage of CMBS will produce an unusual volume of defaults, says Philipp, the Moody’s researcher. “Until a vintage has had at least two years of seasoning, it’s hard to tell if something is a trend or just idiosyncratic,” he says.

An apples-to-apples comparison would match 2006 loans after two years with the performance that 2004 and 2005 vintages exhibited two years into their respective life cycles. “Then if something shows up, that will be significant,” Philipp says.

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