CMBS Credit Quality Shows Some ‘Echoes’ of 2007

Commercial mortgage-backed securities credit quality deteriorated in the first quarter, as more than three-quarters of loans in multiple-borrower bonds were backed by interest-only mortgages, said Moody’s Investors Service, New York.

Moody’s also noted leverage remained high as the average loan-to-value ratio reached 117.3 percent during the quarter, similar to 2007-vintage loans. Debt service coverage deteriorated following a moderate rise in loan coupons and the 10-year U.S. Treasury rate.

On the positive side, coverage and interest rates remained historically favorable, “and pool diversity and our property net cash flow haircuts improved moderately,” Moody’s First Quarter CMBS Review report said.

Levels of interest-only loans in conduit pools “echo” 2007’s interest-only issuance, Moody’s said. The share of IO conduit loans rose to 76.4 percent in the first quarter, the highest percentage since CMBS 2.0 launched. Nearly half of first-quarter issuance was full-term IO, a metric last seen in 2007. “IO loans tend to have higher default rates and loss severity, all else equal, and the prevalence of IO is an important bellwether of deteriorating underwriting standards,” the report said.

Brian Olasov, Executive Director of Financial Services Consulting with Carlton Fields, New York, said rating agencies are supposed to “sound the alarm” when they detect declining standards. “That’s what Moody’s accomplishes with this research,” he said. “The rise of IO loans and full-term IO loans, in particular, is absolutely a credit negative when considered in isolation of other credit metrics.”

Olasov noted that at a 5 percent coupon, a 10-year loan with a 25-year amortization will have paid down to roughly 75 percent of original principal balance at maturity. “The lack of that pay down may lead to refinancing risk in later years,” he said. “But amortization is only one factor out of many and the data does not support a current deterioration to 2007-era credit risk. Far from it.”

For example, look at refinancing risk, Olasov said. Moody’s describes underwriters “preamortizing” current origination. “Sure enough, 2018’s underwritten loan-to-value of less than 60 percent is materially more conservative than 2007’s 70 percent,” he said. “This is before addressing whether 2018’s appraised values are more reliable than 2007’s.”

In addition, rising cap rates exacerbate refinancing risk, Olasov said. Market consensus holds that all rates–Treasury rates, spreads on credit products and cap rates–will climb over the lives of today’s loans. But 2007’s average spread between cap rates and Treasury rates had shrunk to a “paltry” 153 basis points compared to 340 basis points in 2018 year-to-date. Cap rate spread can absorb far more rate volatility than could be tolerated in 2007.

“As an additional note, apart from the fact that 2007’s spreads were tighter than currently, loan-to-values were higher and debt service coverage ratios were substantially lower, 2007 also had higher IO percentages–both partial and full–than we currently see in the market,” Olasov said. “Today’s CMBS are a long way from the ‘good old days’ of 2007.”