A Warning on Risk in Securities backed by Commercial Mortgages

In the wake of the collapse of the subprime residential mortgage market, the leading bond rating agencies are beginning to crack down on what they see as risky lending practices in commercial real estate as well.

Like residential loans, commercial mortgages are pooled and packaged into bonds that are sliced up into portions carrying different degrees of risk. According to Moody’s, there were $769.6 billion in commercial mortgage-backed securities at the end of last year, representing 26.1 percent of all outstanding commercial mortgages, including apartment buildings.

The agencies that rate these securities have issued warnings in the past, but last month they sounded a new note of urgency, saying that for the first time they would adjust their ratings to reflect their concerns.

“Underwriting has gotten so frothy that we have to take a stand,” said Jim Duca, a group managing director at Moody’s Investors Service. “The industry was heading to Niagara Falls.”

Standard & Poor’s said that in the first quarter of this year, the delinquency rate for such bonds reached its highest level since its delinquency index was created in 1999.

Fitch also predicted a 15 percent increase in defaults of loans being currently written and bond analysts agree that a large number of the loans issued recently could result in large problems down the road.

As was the case in the overheated residential mortgage market, many loans for commercial transactions were designed to be borrower-friendly, including interest-only payments for the first 10 years with balloon payments at the end of the term. The agencies point out that, unlike the vast majority of residential loans, commercial lenders are not requiring landlords to set aside adequate reserves to cover taxes, insurance and other costs. Many lenders are prone to accept overly optimistic projections by borrowers, including occupancy and rental rate growth.

While the agencies are just starting to reflect their new credit-tightening standards, their warnings are already having repercussions in the bond market. Investors are demanding higher rates of return, making the bonds costlier for the dealers, said Rob Brennan, the global head of real estate financing for Credit Suisse. “The fact is that the marketplace forces the change immediately,” he said.

Many investors who own these commercial mortgages and mortgage backed securities have experienced default losses. As recent credit rating warnings have caused interest rates to rise on newer loans this has also caused the value of loans and securities held by these investors to fall in value, in some cases precipitously.
Last month, a new $4.2 billion commercial-mortgage-backed security offered by GE Capital had to be restructured after investors complained. Five loans totaling $226.7 million were removed from the offering, and the investment-grade portion of another loan was further trimmed by $50 million. Most of the loans removed from the offering were originated by Deutsche Bank, which also provided $6 billion in debt financing for the purchase nearly all the Manhattan portions of a portfolio. Deutsche Bank declined a request for comment on the restructuring of the GE Capital bond.

Brenan, a securitization industry veteran, said the changes were necessary even though they would result in higher costs to the investment banks. “We’re trading some short-term pain for long-term gain,” he said. “If we do this right, we’ll stop a level of excess from getting out of hand. We want to avoid the kind of train wreck that the subprime market experienced.”

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