Fitch's 2006-2007 CMBS Vintage Resilient in Turbulent Market

MBA (8/1/2008 ) Murray, Michael
In a worst-case scenario, AAA commercial mortgage-backed securities bonds in the United States from 2006 and 2007 vintages would remain solvent and overall losses would not be systemic in a severe economic downturn, based on comprehensive stress tests performed by Fitch Ratings, New York.

“It is Fitch’s opinion that AAA-rated U.S. CMBS bonds are highly resilient to significant economic and property-level stresses,” said Ryan Frank, director in the U.S. CMBS group at Fitch. “As a result, losses on AAA-rated bonds are unlikely even in highly stressed environments.”

The $360 billion in the 2006 and 2007 U.S. CMBS fusion transactions represent nearly half of all outstanding CMBS at Fitch, more than 60 percent of all U.S. CMBS fusion bond issuances for 2006-2007 and 100 percent of its U.S. CMBS fusion securitizations. The subset represents 74 deals, 14,931 loans and $217.3 billion.

Some analysts, however, question underwriting in the 2006 and 2007 CMBS vintages—particularly at maturity—because borrowers may not be able to refinance out of them.

“Traditional lending sources’ capital will continue to get more conservative and less available, both due to continued write-down effects on tier one capital and shareholder tumult over their plummeting stock values. This pain will extend from small to large, regional to national financial institutions,” said Clain Brandt, managing principal at BIHT Ltd. International, a sovereign wealth fund based in the Channel Islands.

“[Financial institutions] can no longer blame all of their problems on the ‘subprime meltdown,’” Brandt said. “The true culprit—construction lending standards—is about to rear its ugly head as the development phase of the last cycle comes to a quick death.”

Fitch placed mild, moderate and severe stresses on the vintages, with the most severe stress simulating a severe economic downturn present during the 1945 recession. It adjusted net cash flow down 30 percent, and GDP and personal income to negative 11 percent and negative 6.5 percent, respectively. Fitch also applied a 40 percent decline in appraised property market values.

The results indicated average loan-level losses at 8.8 percent, bond-level losses at 90 percent for all A-rated categories and 20 percent in all AA-rated categories.

“It is noteworthy that even in this extreme stress environment, no AAA-rated classes incurred losses,” Frank said. “On an individual transaction basis, the single highest-rated class to incur losses was rated AA+.”

The moderate scenario—similar to the 1991 recession with 15 percent declines in net cash flow and 25 percent declines in property values—95 percent of all BB-rated categories experienced losses, and the highest-rated loss occurred twice from BBB-plus-rated classes.

In a mild stress scenario—economic conditions similar to the 2001 recession with 10 percent net cash flow declines—the highest-rated class to incur losses was BBB-minus seven times as losses reached as high as the B-rated class in six instances.

“Notably, both mild and moderate stress simulations indicate no losses to any single A, double A or triple A-rated categories,” Frank said.

“While we feel that these results are accurate in general, we don’t anticipate that losses will be systemic in nature,” he added. “Instead, we expect that losses will vary based on unique-view characteristics, such as property type or geographic concentrations.”

Despite resiliency in the 2006 and 2007 CMBS vintages from Fitch’s stress model, some investors remain skeptical about the CMBS market’s short-term future.

“The securitization [CMBS/CDO] industry faces a rough, uphill challenge that it must overcome in order to again function,” Brandt said. “Until confidence is restored as a result of greater transparency, accountability and simplicity in its basic business model, combined with the rating agencies ability to show they operate at an arm’s-length-distance from the securitizers, investors will shy away from this capital market.”

Nearly one year ago, investors lost confidence in the CMBS market as losses from subprime residential mortgage-backed securities spilled over into panic toward the CMBS market, cutting off the flow of liquidity from CMBS investors.

However, Susan Merrick, managing director and head of Fitch's U.S. CMBS group, said subprime loans did not have the same underlying facts and information about the underlying credit of the borrowers and the property.

“In the subprime market, you really did see defaults increasing substantially. We don’t have that in CMBS. We have overall defaults for the entire Fitch portfolio of roughly 40 basis points. While it’s not an all-time low, it’s fairly close to it,” Merrick said. “We do see that defaults will increase in part because the portfolio is aging, but we don’t see a wave of defaults coming.”

She noted the main difference in subprime and commercial real estate loans, is reliance on the cashflows borrowers receive at the property level, and that cashflows depend on individual tenants or, in theory, “industries paying their rent.”

“It is very much an independent third party and [investors] are not relying directly on the consumer,” she said.

Even with cashflow payments from tenants, the ability of financial institutions to raise additional capital through equity offerings “has come to a screeching halt,” Brandt said.

“They must now shed core assets in order to survive, at least to the point where mark-to-market valuations have been established,” he said.

Fitch recognizes the ratings agency’s “opinion differs from some others in the market,” Merrick said.

Despite economic changes and uncertainties taking place in the capital markets, Merrick said Fitch continues to test ratings, methodologies and models and stress them under numerous circumstances to make sure they address and take into account "all of the implied risks within the asset sector as well as any exogenous risks.”

“We have made a number of changes at Fitch structurally, and we are providing a number of rating enhancements—one of which is the outlook we spoke of here,” Merrick said. “Here, as well, there is a lot of change afoot.”