Standard & Poor’s this week completed a significant re-analysis of its rated universe of US commercial mortgage backed-securities (CMBS). The results are either alarming or wholly unsurprising, depending on how closely you’ve been following the saga of US commercial real estate.
It also (as a result of the review) put nearly $100bn of CMBS on watch for possible downgrade.
Per S&P, emphasis FT Alphaville’s:
The economic recession combined with the absence of readily accessible financing in the capital markets has, in our opinion, skewed the credit risks related to the performance of CMBS sharply to the downside, and far in excess of what we expected at origination or in our prior scenario analysis. As a result, our baseline (or expected) case now reflects a more severe recession, with a peak unemployment rate forecast of 9.8%.
Since September/October 2008, we’ve witnessed significant deterioration in the credit performance of the CMBS transactions we rate. Our scenario analysis tests the resilience of our ratings on a loan-by-loan, deal-by-deal basis while factoring in the current and expected economic environment.
S&P expects a wide dispersion in performance both across different CMBS vintages, and even between particular deals within those vintages. The rating agency is particularly downbeat on the 2007 vintage, which it assigns an average expected loss – in the base case – of 10 per cent. This compares with 5.2 per cent for 2006 deals, and 2.5 per cent for 2005.
Furthermore (emphasis added):
The range of expected losses in our base case for 2007 vintage transactions was 0.5%-32.6%.
In our “stress” case, the average expected loss for the 2007 vintage is approximately 20%. Coming in much lower are the 2006 and 2005 vintages, at 13.4% and 8.0%, respectively.
* In our baseline (expected) case, the majority of the 20% credit-enhanced ‘AAA’ classes (AM classes) are likely not at risk for downgrade. However, some of these classes within what we believe will be the worst performing 2007 vintage deals appear to be potentially vulnerable over their 10-year lives.
* The majority of all junior ‘AAA’ rated securities (AJ classes) are likely vulnerable to downgrade. Of the total number of these at-risk classes, approximately 50% are from 2007 vintage transactions. Transactions we expect to display the worst performance may eventually see AJ classes transition to speculative-grade ratings.
* We expect most speculative-grade classes from the 2005-2007 vintages to take principal losses. We also expect many transactions from the 2006 and 2007 vintages to eventually suffer losses at the low-investment-grade rating categories.
S&P notes that performance in the 2005-2007 vintages will be much worse than earlier deals, “because the underlying transactions generally had more aggressive loan underwriting and lower credit enhancement”:
Examples of more aggressive loan underwriting include employing higher leverage (measured by LTV), widespread inclusion of interest-only periods (many for the entire term of the loan), and lowered required reserve amounts. In addition, many of the transactions included loans with initial DSCs below 1.0x based on in-place cash flow, with the expectation of future significant increases in cash flow after origination (pro-forma underwriting).
More bad news for the banks, undoubtedly.
Related links:
“the banking sector is much more sensitive to a downturn in commercial real estate than in housing“ – FT
Real estate sector fears huge increase in US CMBS defaults – FT
Ominous signs for Europe’s CMBS outlook – FT
Fitch study points to high UK CMBS risk – FT