Mortgage Securities: What is Happening?

By Brian Bader, CPA

Are we now in a new world of constantly rising values for real estate supported by constantly rising cash flows? Or are optimistic predictions as to future income growth merely a rationalization to justify constantly rising real estate prices (as well as prices for other assets). In a report titled "US CMBS and CRE CDO 1Q 2007 Surveillance Review," Moody's Investors Service asks: What is really happening in the market for mortgage securities?

Moody's assessment of property performance normally includes a reasonable allowance for the normal fluctuations in operations (i.e., vacancy rising and falling). Further - more, mindful that vacant space is not to be valued at zero, Moody's seldom downgrades an issue unless property performance is meaningfully below initial expectations. This reflects the fact that loans placed in fixed-rate mortgage conduits are initially performing around peak levels, hence the borrower's desire to arrange long-term financing to capitalize on this circumstance. At the same time, the normal expectation is that a property's performance will gradually improve while the loan is gradually amortized, thus creating an upside in quality.

However, says Moody's, in the new world of underwriting, more and more upside is being taken into account up front, sometimes to the point where the in-place DSCR (debt service coverage ratio) is well below the underwritten DSCR. (The DSCR is the ratio of net operating income to annual debt service; thus if NOI is $10,000 and annual debt service is $6,000, the DSCR is 1.66. The higher the DSCR, the less likelihood there is of a default.) Thus, if the initial DSCR already anticipates future improvement in performance, future upside is less likely and the risk of future default is increased.

Notwithstanding the above, during the first quarter of 2007, upgrades continued to outpace downgrades. In 102 securitizations with 1,201 CMBS classes, Moody's made 919 affirmations and confirmations, 251 upgrades and 31 downgrades. For the investment-grade classes, upgrades exceeded downgrades by a wide margin of 229 to 7. For below-investment grade classes, upgrades and downgrades were fairly evenly split (22 to 24). Roughly 76 percent of the classes were unchanged.

The B-piece players who buy the lowest-rated tranches are supposed to "police" the market, throwing out bad loans from the package in a CMBS or CDO. But the policing appears to be becoming less effective because of the many financial options that B players have to otherwise minimize their risk. As one commentator noted, the B players are increasingly hedging their positions or transferring weakening holdings to the CDO market, thus reducing their exposure to loss (and so giving them less inducement to kick out bad loans). Offsetting this to some extent, is increasing scrutiny of the commercial debt markets by the rating agencies. For example, Moody's has announced it will increase its subordination requirements after many years of loosening them.

Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman’s New York office. He can be reached at (212) 885-8203.

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