Fitch Sees Signs of CMBS Stress

With 10 business days to go, CMBS issuance is on track to top $200 billion in 2006, a new record. But Fitch Ratings warns a worrisome amount of the loans that were securitized this year are concentrated in volatile property types or are interest-only obligations.

“As issuance volume grows, recent vintages have become more volatile,” Fitch Ratings Senior Director Patty Bach said during a conference call with reporters and analysts on Dec. 13. Bach pointed to a surge in hotel lending, which is regarded as riskier than property types that get their cash flow through long-term leases, not overnight visits.

Hotel loans accounted for16.3% of all commercial mortgage-backed securities issued in 2006, according to Bach, and for the first time surpassed the multi-family assets in CMBS. The share of hotel properties has been on the rise in CMBS since hitting a post 9/11 low of 2.3%.

Interest-only loans are another red flag, because borrowers who use such instruments may be exceedingly vulnerable to economic downturns. Bach says that Fitch has seen the percentage of interest-only loans in multi-borrower deals rise in 2006 and predicts that the number will rise in 2007, too, although the company does not have precise data on the issue.

Fitch contends riskier lending practices are the result of rising competition among loan originators seeking product and profitability. “Fitch also expects Vintage 2007 to be more volatile than earlier vintages,” Bach says.

Brian Lancaster, head of structured products at Wachovia Securities, agrees that the rising proportion of hotels, land and other potentially volatile asset classes in CMBS pools can increase the industry’s risk in the event of economic downturns. However, he says other factors are in fact making asset pools more stable.

Specifically, CMBS pools are seeing an infusion of ultra-safe government-backed instruments due to widespread defeasance. In the defeasance process, borrowers are permitted to replace a note with a safer asset, such as a package of Treasury bonds. Borrowers have been using defeasance to replace high-rate loans and lock in lower rates. Lancaster says that about 7% of CMBS deals are now backed by U.S. Treasuries or similar, low-risk securities. By the end of 2007, that percentage could reach 13%, he predicts.

“Upgrade-to-downgrade ratios in CMBS are going to be off the charts again because of all the defeasance in the market,” he says.

Fitch reported its CMBS outlook and other findings in its Global Structured Finance Outlook report, released this week. Although critical of the increasing volatility in CMBS, Fitch describes issuance as robust and likely to remain so through the coming year. With 2006 volume expected to top the 2005 record of $169.2 billion by 20%, 2007 will likely see volume climb another 20% to top $240 billion.

Some other highlights of the report:
• Single-borrower CMBS has experienced a rise in cell towers, timber and other esoteric asset types.
• Large-loan CMBS transactions included more non-traditional property types in 2006, such as condo conversion loans and merger and acquisition financing loans, such as the transactions used to finance deals for Toys ‘R Us, Lord & Taylor, Albertsons and Mervyn's.
• The number of the CMBS fusion transactions — which combine one or more large loans with numerous small ones — in excess of $3.5 billion in value has also increased. The trend of larger fusion deal sizes will likely continue into 2007, according to Bach. “Fitch has already seen five $3.5 billion-plus deals through the first nine months of this year, and expects a total of nine such deals by year-end, compared to five in 2005.”
• Fitch reported an upgrade-to-downgrades ratio of 35.5:1 for multi-borrower CMBS deals through the first nine months of 2006, and 29:1 for large-loan, floating-rate transactions. Upgrades may slow in 2007, especially for CMBS loans containing non-traditional assets. “CMBS secured by stable assets will continue to perform well, while those secured by less traditional, transitional properties will remain higher risk,” says Mary MacNeill, a managing director at Fitch.

The report is available on the Fitch Ratings web site at

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