V O L U M E

N U M B E R

A P U B L I C AT I O N

OF

THE

C O M M E R C I A L M O RT G AG E S E C U R I T I E S A S S O C I AT I O N

Conduit CMBS Balloon Risk in a Rising Rate Environment

THE POOL REFINANCE LOSS FACTOR
PLUS: COMMERCIAL MORTGAGE DEFAULTS: 30 YEARS OF HISTORY RISING INTEREST RATES IMPACT ON FLOATING RATE CMBS INTEREST RATES AND IO LOANS: AN ANALYSIS OF BALLOON AND TERM RISK LODGING REVISITED: HOSPITALITY SECTOR IS ON THE MEND FDIC CLOSES THE BOOKS ON RTC SECURITIZATION PROGRAM

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Editorial Board

Publisher JOSEPH PHILIP FORTE Dechert LLP

Editor-in-Chief JUN HAN John Hancock Real Estate Finance, Inc.

Managing Editor BRIAN P. LANCASTER Wachovia Securities

Managing Editor GALE SCOTT Standard & Poors

NEIL BARVE Lehman Brothers Inc. (2005-2006) STACEY BERGER Midland Loan Services, Inc. (2004-2005) TONY CIOCHETTI Massachusetts Institute of Technology (2004-2005) PATRICK J. CORCORAN JPMorgan Chase (2004-2005) MARGIE CUSTIS Principal Global Investors (2004-2005) HOWARD ESAKI Morgan Stanley (2004-2005) MICHAEL EVANS ABN AMRO/LaSalle Bank N.A. (2004-2005) JOSEPH PHILIP FORTE Dechert LLP (2004-2005) DAVID GELTNER Massachusetts Institute of Technology (2003-2004) SALLY GORDON Moodys Investors Service (2004-2005) MARK HILL NorthMarq Capital, Inc. (2004-2005) ERIC M. HILLENBRAND (2004-2005) JOSEPH HU Standard & Poors (2004-2005)

DAVID P. JACOB Nomura Securities International, Inc. (2004-2005) MARTIN LANIGAN Mezz Cap (2004-2005) GAIL G. LEE Credit Suisse First Boston LLC (2005-2006) REGINALD LEESE State Street Research and Management Company (2005-2006) JACK NOWAKOWSKI Pension Real Estate Association (2005-2006) MARY OROURKE FitchRatings (2005-2006) RICHARD PARKUS Deutsche Bank (2004-2005) LISA PENDERGAST RBS Greenwich Capital (2004-2005) TIMOTHY RIDDIOUGH University of Wisconsin, Madison (2005-2006) CHARLES G. ROBERTS Cadwalader, Wickersham & Taft LLP (2004-2005) PETER RUBINSTEIN Bear, Stearns & Co. Inc. (2005-2006) JOAN SAPINSLEY Teachers Insurance and Annuity Association (2004-2005)

PATRICK SARGENT Andrews Kurth LLP (2005-2006 ) JOHN SCHEURER Allied Capital Corporation (2004-2005) JONATHAN SHILS Powell, Goldstein, Frazer & Murphy LLP (2003-2004) KELLY SMALL American Council of Life Insurers (2004-2005) ROBYN STERN Ernst & Young LLP (2004-2005) JAMES F. TITUS Realpoint (2004-2005) JACK TOLLIVER Dominion Bond Rating Service Limited (2005-2006) RICHARD C. TREPP Trepp, LLC (2004-2005) MARILYN WEITZMAN The Weitzman Group, Inc. (2003-2004) DARRYL WHEELER Citigroup Global Investments (2004-2005) TOM WRATTEN Principal Commercial Acceptance, LLP (2004-2005)

CMSA Officers

President RICHARD D. JONES Dechert LLP President-Elect MARGIE CUSTIS Principal Global Investors Immediate Past President JOSEPH C. FRANZETTI Citigroup Global Markets

Vice President JOHN M. SCHEURER Allied Capital Secretary WILLIAM GREEN Wachovia Securities

Treasurer KENT BORN PPM America, Inc. Chief Executive Officer DOTTIE CUNNINGHAM Commercial Mortgage Securities Association

Advisory Committee

JUN HAN John Hancock Real Estate Finance, Inc. JOSEPH PHILIP FORTE Dechert LLP ANNEMARIE DiCOLA Trepp, LLC

BRIAN LANCASTER Wachovia Securities GALE SCOTT Standard & Poors JEFFREY FASTOV Goldman, Sachs & Co.

JOSEPH C. FRANZETTI Citigroup Global Markets DOTTIE CUNNINGHAM Commercial Mortgage Securities Association

TM

F E AT U R E S
1 3 Conduit CMBS Balloon Risk in a Rising Rate Environment
The near universal use of lockout and defeasance structures will reduce balloon risk if interest rates rise over the next few years.
Peter Rubinstein and Alan Todd

DEPARTMENTS
1 2 4 7 Editors Page
Peter Rubinstein and James Titus

Canadian Corner
Pamela Spackman and Kenneth Toten

1 6 The Pool Refinance Loss Factor

A warning to investors based on ARCaps loss methodology.
Larry Duggins

Legal Corner
Mark A. Weibel and Mark L. Patterson

CMBS Collateral Performance

Thomas A. Fink

2 1 Commercial Mortgage Defaults: 30 Years of History

A new study covering the time period 1972-2002.
Howard Esaki and Masumi Goldman

1 0 CMBS Index Returns

Neil Barve

1 1 Calendar of Events

3 1 Rising Interest Rates Impact on Floating Rate CMBS

How will debt service coverage, credit ratings and support levels hold up under stressed scenarios?
Frank Innaurato, Stephen Kuritz, Kevin Hendrickson and Robert Grenda

5 8 Hot Website Links/ Submission of Manuscripts for Consideration

PUBLISHER Joseph Philip Forte EDITOR-IN-CHIEF Jun Han MANAGING EDITORS

3 7 Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

This structure has caused concern among many investors because they fail to reap any of the benefits of amortization.
Paul Staples and Sally Gordon

Brian P. Lancaster, Gale Scott

GUEST CO-CONTRIBUTING EDITORS

Peter Rubinstein, James Titus

ASSOCIATE EDITOR Ken Cuffee COPY EDITOR Hildy Mesnik ART DIRECTOR Delfin Chavez Design CHIEF EXECUTIVE OFFICER Dottie Cunningham MANAGING DIRECTOR, RESEARCH/STANDARDS Shane Beeson DIRECTOR, COMMUNICATIONS Jane Marrinan ADMINISTRATIVE ASSISTANT, COMMUNICATIONS Elizabeth Hanes

4 4 Lodging Revisited: Hospitality Sector is On the Mend

Are hotel loans still among the worst performing CMBS property types?
Kim Betancourt, Peter P. Kozel and Michael J. Magerman

5 0 FDIC Closes the Books on RTC Securitization Program

Some of the most significant legacies of the RTC program were the prominence and major contributions made in the development of the CMBS market.
George Alexander and Tom Raburn

MANAGING DIRECTOR, FINANCE/ADMINISTRATION Jane A. Gelfand

VOLUME 6, NUMBER 4 CMBS World TM is published quarterly by the Commercial Mortgage Securities Association (CMSA), 30 Broad Street, 28th Floor New York, NY 10004-2304 phone: (212) 509-1844 email: info@cmbs.org website: www.cmbs.org 2005 CMSA Commercial Mortgage Securities Association, all rights reserved. ADVERTISING: For information regarding advertising within CMBS World TM, please contact: Jane Marrinan, CMSA phone: (212) 589-0961 fax: (212) 509-1895 email: jane.m@cmbs.org SUBSCRIPTIONS: Subscriptions of CMBS World TM can be obtained for $100 per year. Please contact: Elizabeth Hanes, CMSA phone: (212) 509-1454 fax: (212) 509-1895 email: elizabeth@cmbs.org EDITORIAL: Questions? Comments? Send queries and letters to: Letters to the Editor Jun Han, Editor-in-Chief, CMBS World TM John Hancock Real Estate Finance, Inc. 200 Clarendon Street T56 Boston, MA 02117-0111 email: jhan@jhancock.com CMBS World TM assumes no responsibility for the loss or damage of unsolicited manuscripts or graphics. We welcome articles of interest to readers of this magazine. Opinions expressed are those of the author(s) and not necessarily those of CMSA.

DIRECTOR, REGULATORY Stacy Stathopoulos EXECUTIVE MANAGER, CMSA-EUROPE Carol Wilkie DIRECTOR, MEETINGS Patricia A. Madonia DIRECTOR, TECHNOLOGY Christopher Butcher DIRECTOR, FINANCE James Keller MEMBERSHIP COORDINATOR Marcus T. Henderson MEETINGS COORDINATOR Lisa Zebrowski MEETINGS REGISTRAR Dekar Benedict EXECUTIVE ASSISTANT Alicia Quigley ADMINISTRATIVE ASSISTANT Laura Baran
COVER ART Delfin Chavez

NEXT ISSUE:
A timely and relevant look at the topic of large loans and their growing inclusion in CMBS transactions.

E D I T O R S PA G E

Rising Interest Rates Impact on CMBS Market

Last summer, when the Editorial Board was considering topics for the winter issue of CMBS World , the thought of significantly higher interest rates was on the minds of many members. Since then, rates have risen, and fortunately for the economy, Fed hikes so far have affected mostly the short end of the curve with only a limited impact on longer duration bonds. But the question still remains: how will significantly higher interest rates impact the pricing and creditworthiness of CMBS bonds in the market?
TM

Rubinstein

small, but the impact of rising rates is immediate and there are a large number (over $15 billion) of floating rate loans that will be maturing and facing the risk of refinancing in a higher rate environment over the next two years. Then, Sally Gordon and Paul Staples return the focus to fixed-rate balloon risk, but in what is perhaps the most sensitive part of the conduit marketIO loans. They note that while the risks are real, once these loans start to amortize, the much faster rate of amortization on low coupon IO loans can offset a significant amount of the balloon risk at maturity. While the impact of rising rates is important, we have also selected several articles in this issue that touch on other important topics. Howard Esaki and Masumi Goldman present an update to the CMBS markets first, classic, and now longest running, benchmark study of long-term default rates on life insurance company commercial real estate loans. The Senior Research Team at Realpoint presents an update on the hotel market and concludes that this sector, after a difficult few years, has finally turned the corner. And last, the CMBS market owes a debt of gratitude to the government for deciding to use securitization as a means to dispose of loans acquired during the savings and loan crisis of the late 1980s. The RTC not only broke the ice, they also paved the way for the private market to make CMBS a permanent part of the fixed-income universe. With the final wind down of the last RTC pool, George Alexander and Tom Raburn present an incisive historical retrospective of the RTC program and its legacy to the markets.

In this issue, youll find four articles that address the impact of rising rates from four different angles. First, Peter Rubinstein and Alan Todd note that many of the low coupon conduit loans made over the past year or so may never face refinancing risk. In a high rate environment, there is a powerful incentive for borrowers to defease the loans before they ever reach maturity. Next, Larry Duggins article switches the focus to the conduit market and presents a clear and fascinating look at how B-piece buyers evaluate risk. Their concern, no doubt shared by many, is that borrowers may have difficulty refinancing loans that were made at the unusually low rates offered over the past year or two if future rates and spreads rise back to historical long term norms.
Titus

The CMBS Research Team at Realpoint presents a quantitative analysis of the potential impact of rising rates on floating rate CMBS where, as they note, the market may be

We would like to thank Jun Han, Gail Scott and Brian Lancaster for their editorial support and guidance, as well as the ongoing publishing assistance from Shane Beeson and the entire CMSA staff.

Peter Rubinstein, Ph.D. Managing Director, Bear Stearns & Co. Inc. Guest Co-Contributing Editor, CMBS World

TM

James Titus Managing Director, Realpoint/GMAC Institutional Advisors Guest Co-Contributing Editor, CMBS World
TM

WINTER 2005

CANADIAN CORNER

The First Annual Canadian CMSA Conference

Pamela Spackman and Kenneth Toten

More than 225 people gathered at the Hilton Toronto on October 25-26 for the inaugural Canadian CMSA Conference. The conference began on Monday with a roundtable seminar called The CMBS Cafe. Sally Gordon, Moodys Investors Service, moderated Winning smiles from our winning an expert panel of Conference Chairs (and co-authors of this representatives from article), Pamela Spackman, Column a rating agency, an Canada Financial Corporation (left); issuer and an and Kenneth Toten, Coventree Capital investor. Each Group, Inc. panelist described their individual roles within the CMBS market and how they fit into the larger picture of the securitization process. The dialogue between panel and audience was excellent, and the informal session provided a perfect opportunity for attendees to fill in the gaps in their CMBS knowledge. The conference got underway in earnest the next morning with a real estate market overview from John OBryan, TD Securities. OBryans presentation expanded on the fact that real estate in Canada is a favored asset class with low costs, abundant financing and liquidity in all sectors. Buyers include pension funds, life companies and REITs, as well as private domestic and offshore entities. On the topic of new office supply, OBryan noted that there are 14 office properties under construction in Toronto representing approximately 1,777,000 square feet, as well as four properties in Calgary totaling approximately 1,230,000 square feet. He also touched on the top investor property types, including multi- and single tenant industrial properties, as well as food-anchored retail strip centers. He concluded his excellent overview by explaining that supply and demand of office space is in good balance, REITs with access to product have been favored by investors and that interest rates remain the main variable. The first panel of the day took a page from the popular television show Crossfire. Moderator David Allan, CIBC World Markets, guided a debate pitting all four rating
2 CMBS WORLD

agencies against a group of industry practitioners that included a AAA investor, a B-piece buyer, a mortgage originator and an issuer. The opening salvo from the investors postulated that the rating agencies favor the originators/issuers (the rating agencies denied any bias!). The AAA investor moaned that as theyre getting the worst of both worlds tightening credit spreads and lower subordination levelshow can they decide to buy? The originator strongly disagreed, saying that, in fact, subordination levels are too high! In order for the agencies to lower them, they have to come to terms with the fact that default rates on CMBS product are lower than default rates for ABS or corporate debt. The issuer chimed in to say that he feels the problem with origination isnt so much with the rating agencies as it is too many lenders chasing too few borrowers. Finally, the B-piece investor added that the mortgage market is now as competitive as it has ever been, and a sure sign that we are close to the top of the market is that limited partnerships are now re-entering the market. A lively debate ensued, covering many areas of interest to the audience, including questions such as the role of A/B structures in rating pools. There was uniform agreement among the conference attendees that the Crossfire format made for the most interesting and informed review of topical CMBS issues. The conference then moved on to the international marketplace with an insightful panel moderated by Darrell Wheeler, Citigroup Global Markets. Representatives from

Registration at inaugural Canadian CMSA Conference, Toronto.

Canadian Corner

(cont.)

David Allan, CIBC World Markets (center), moderates lively Crossfire-style debate pitting rating agencies against CMBS industry practitioners.

Canada, Europe, the U.S., and Japan discussed the component parts of how global issuance in 2004 may exceed $122 billion. Some salient points were that U.S. issuance has lately been dominated by structured large loans which make use of A/B structures and pari passu arrangements. The exploding European market is shifting towards greater diversification, and from single property to Continental multi-property transactions. In Japan, issuance of securitized products is expected to hit a record this year. The issuance of CMBS has been extremely stable over the past few years, now sharing approximately 20% of the market. Canada issued $2.4 billion in 2004 which was lower than 2003. There were no large single asset deals securitized in 2004, which accounted for approximately $700 million. In 2005 Canada will likely see more fusiontype deals and A/B structures but is unlikely to follow the U.S. too soon on the pari passu securitizations. An expert investment panel, moderated by Jennifer Shum, TD Securities, finished up the morning by examining the relative value of CMBS bonds versus other whole loan and fixed income investments. One main question was, How does CMBS help capital constrained investors? Thoughts from the panel included the fact that the product provides good relative value compared with corporate bonds, and that there is great opportunity in CMBS to buy at various levels of risk. Diversification by property type and region was also noted as an important benefit of CMBS. Another interesting area debated was, How does an investor analyze whether or not they should invest in below AAA CMBS? Suggested factors to look out for included the usual suspects of DSCR, recourse, the steepness of the credit curve, and the top ten loans in a deal.

After a luncheon keynote address by Deirdre McMurdy, co-anchor of Moneywise, and Anthony Wilson-Smith, editor of Macleans magazine, where current economic and political issues were aired (including a correct prognostication by Wilson-Smith that George Bush would win the election), the attendees returned to a panel on IOs and B-pieces, moderated by Louis Neretlis, Royal Bank Financial Group. This excellent panel included the most active B-piece buyers and the most active IO investor in the country and supplied the audience with a very pragmatic inside view of the issues that affect their decision making and how they look at A/B structures. Next up was a discussion on CMBS Current Issues, moderated by Pierre Dennis Leroux, McCarthy Tetrault. Of particular note in this panel was a discussion on the role of servicing in CMBS. The roles of the primary, master and special servicers were outlined and debated, and a good amount of time was spent on servicing hot topics including how they deal with A/B note structures, pari passu mortgages in multiple pools and borrower satisfaction. The final panel of the day, moderated by Lawrence Small, Scotia Capital, focused on a diverse set of investor issues. One investor took a look at the liquidity profile of CMBS versus whole loans, while another weighed the advantages of CMBS against corporate bonds. A third panelist stressed the importance of portfolio diversification. The final investor concluded that Canadian CMBS has done very well across the board, and that it deserves the continued improvement in rating agency enhancement levels based upon default and loss performance. Interspersed was a debate on whether or not a triple-A is a
(continued on p. 55)
WINTER 2005 3

LEGAL CORNER

Principal/Agency Issues Facing Participants in the CMBS Industry

Mark A. Weibel and Mark L. Patterson
Since 1994, CMBS have become an impressive addition to the capital markets landscape. With more than $345 billion outstanding, the CMBS sector has developed a broad investor base and a liquid secondary market. The growth is due, in large part, to the attractive higher yield the instruments present compared with traditional corporate bonds, asset backed securities, residential mortgagebacked securities and government securities.

...as agency is an affirmative defense, the agent shoulders the burden of proving

Weibel

Considering all of the entities involved in a typical CMBS structure, it is not surprising that legal issues of all types and complexity can arise. Moreover, even the simplest legal issues can create enormous exposure for the parties, especially trustees and servicers. Below, we cover principal/agency law and one real life horror story.
Patterson

incorporation on file with the secretary of state. In like manner, caution dictates that a trusts name should be fully and carefully verified to its original core documents, including the trust indenture and filed trust certificate. Imagine if an agent attempts to claim it was acting on behalf of a principal whose name was incorrectly disclosed to a third party because the agent failed to verify the proper spelling, misused Inc. or Corp. in the name, or deviated from the true name of the entity in other similar ways. The third party could argue that it was only partially aware of the principal (i.e., aware only of its existence, but not its true identity). Unfortunately for the agent, it is the third partys actual knowledge , not what she should have known, at the time that controls. Further, as agency is an affirmative defense, the agent shoulders the burden of proving that it was acting on behalf of a fully and properly disclosed principal.

THE PRINCIPAL/AGENCY RELATIONSHIP WHOS BOSS?

THE

REAL LIFE EXAMPLE

In the 1991 case of Patel vs. Whiteco Industries, Inc.,1 the Texas Court of Appeals in Dallas rendered a harsh, but not surprising, opinion well-founded in the law. In Patel, an advertising company sought to collect unpaid advertising fees on contracts executed by Mr. Patel on behalf of a motel management company. Mr. Patels actual capacity was President of Delux Management Company, his true principal. However, he executed one contract as President of Delux Inn Management Company, Inc. Although Patel provided proof to the court that he acted in an authorized capacity on behalf of Delux Management Company, that fact alone was insufficient to relieve him of personal liability. The court correctly applied the rule that disclosure of the existence of a representative capacity, absent fully and properly identifying the true principal, is insufficient to relieve the agent from personal liability. In the CMBS context, cutting text in the signature block could cause a special servicer or trustee to be individually pursued as a party to the contract. In the examples on the next page, consider how they differ:

In the typical CMBS structure, the trust is the principal and each of the trustees and servicers is an agent. Fundamental to principal and agency law is the rule that an agent is not liable for actions which are performed within the scope of the agents authority and done so on behalf of a principal if the agent fully andproperly identifies to the third party the principal for whom the agent is acting. Otherwise, the agent may be deemed to be a party to the contract, thereby becoming personally bound and liable under the contract. Most individuals can comprehend the importance of fully and properly identifying and disclosing the principal, but many fail miserably to include the true name of the principal, often for no reason other than lack of attention to detail. Texas cases contain harsh consequences for an agents failure to fully and properly disclose the true identity of its principal. Recall that in any business venture legal due diligence mandates that a corporations exact name (e.g., spelling, punctuation, capitalization, etc.) be checked against the name appearing in its articles of
4 CMBS WORLD

Legal Corner (cont.)

PARTIALLY-DISCLOSED PRINCIPAL: THE FIRST NATIONAL BANK, AS TRUSTEE By: Speedy Special Servicing, Inc., a Delaware corporation,

UNDISCLOSED PRINCIPAL: [No Mention of the Trust] SPEEDY SPECIAL SERVICING, INC., a Delaware corporation,

and
By: ________________________________ Name: _____________________________ Title: ______________________________ By: ________________________________ Name: _____________________________ Title: ______________________________

versus

FULLY-DISCLOSED PRINCIPAL: THE FIRST NATIONAL BANK, AS TRUSTEE, FOR THE REGISTERED HOLDERS OF INVESTCO COMMERCIAL MORTGAGE PASS-THROUGH CERTIFICATES, SERIES 2005-C1 By: Speedy Special Servicing, Inc., a Delaware corporation, as authorized agent in its capacity as special servicer pursuant to that certain Pooling and Servicing Agreement, dated as of January 1, 2005 By: _____________________________________________ Name: __________________________________________ Title: ___________________________________________

In the CMBS context, it may be quite common for a master or special servicer to fail to write out the full and complete name of the trust on whose behalf it is acting. The words master/special servicer in an authorized capacity in the signature block or elsewhere, without at least also identifying the complete name of the trust, create a risk that the servicer could be individually pursued as a party to the contract.

Unfortunately, a drafters attention to detail at the end of a

to most fully and accurately disclose each partys name and their relationship to each other is the signature block at the very end of a document. Unfortunately, a drafters attention to detail at the end of a document is not as sharp as it is at the beginning. Nevertheless, as seen in Patel, a drafters failure to fully understand the law of principal/agency, as well as failing to attend to the highest level of detail throughout a document, including the signature block, can place a master or special servicer at substantial risk of becoming personally and individually liable for the items and amounts required by the agreement.

CONCLUSION

Fully and properly disclosing a securitized trusts name, and fully and properly disclosing the servicers name (as well as the title and date of the pooling and servicing agreement creating the principal/agency relationship), is difficult and time consuming. Normally, the best location

Mark A. Weibel and Mark L. Patterson are Partner and Counsel, respectively, of the Dallas office of the law firm of Fulbright & Jaworski L.L.P.
1

No. 05-90-01419-CV (Tex. App. Dallas, July 23, 1991) (not designated for publication), 1991 WL 134576.

WINTER 2005

6 CMBS WORLD

CMBS COLLATERAL PERFORMANCE

Trepp Conduit CMBS Market Monitor

CMBS conduit delinquencies continue to decline from the peak reached at the end of 2003/beginning of 2004. Improved performance is reflected in both the absolute and relative levels of delinquent and nonperforming loans.
Fink

Thomas A. Fink
Chart 1: Conduit CMBS Loan Performance

2.50% Collateral Cut-Off Date 2.00%

% of Loan Balance

90.00% 80.00% Non-Performing Delinquency 70.00% 60.00%

1.50% 50.00% 1.00% Delinquencies 0.50% Non-Performing Ratio 0.00%

99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 4/ 7/ 10/ 1/ 4/ 7/ 10/ 1/ 4/ 7/ 10/ 1/ 4/ 7/ 10/ 1/ 4/ 7/ 10/ 1/ 4/ 7/ 10/
10 /1 / 98

40.00% 30.00% 20.00% 10.00% 0.00%

LOAN PERFORMANCE
Overall delinquencies continued to decline, reaching 1.41%. Delinquencies are now back to the levels of the fourth quarter of 2001.

Chart 2: Delinquencies and Non-Performing

Date 6/1/98 7/1/98 8/1/98 9/1/98 10/1/98 11/1/98 12/1/98 1/1/99 2/1/99 3/1/99 4/1/99 5/1/99 6/1/99 7/1/99 8/1/99 9/1/99 10/1/99 11/1/99 12/1/99 1/1/00 2/1/00 3/1/00 4/1/00 5/1/00 6/1/00 7/1/00 8/1/00 9/1/00 10/1/00 11/1/00 12/1/00 1/1/01 2/1/01 3/1/01 4/1/01 5/1/01 6/1/01 7/1/01 8/1/01 Delinquency % 0.21% 0.38% 0.27% 0.19% 0.21% 0.35% 0.33% 0.36% 0.45% 0.38% 0.35% 0.45% 0.48% 0.54% 0.54% 0.54% 0.52% 0.58% 0.58% 0.64% 0.67% 0.73% 0.71% 0.75% 0.70% 0.73% 0.69% 0.77% 0.68% 0.67% 0.85% 0.91% 0.99% 1.02% 0.98% 1.01% 0.95% 0.99% 1.02% Non-Performing % 0.05% 0.06% 0.04% 0.03% 0.04% 0.12% 0.11% 0.12% 0.17% 0.17% 0.18% 0.19% 0.20% 0.30% 0.31% 0.32% 0.28% 0.30% 0.28% 0.33% 0.33% 0.37% 0.40% 0.43% 0.46% 0.43% 0.42% 0.46% 0.46% 0.48% 0.49% 0.54% 0.65% 0.63% 0.67% 0.69% 0.66% 0.66% 0.68% Ratio 21.96% 16.19% 14.64% 16.70% 19.11% 34.59% 34.21% 32.00% 37.24% 45.00% 50.87% 43.28% 41.89% 55.79% 56.88% 59.53% 53.60% 51.94% 47.45% 52.01% 49.44% 51.26% 55.78% 57.42% 65.21% 59.18% 61.01% 60.00% 67.35% 70.89% 57.48% 59.58% 66.28% 62.22% 68.15% 68.75% 69.28% 66.76% 66.61% Date 9/1/01 10/1/01 11/1/01 12/1/01 1/1/02 2/1/02 3/1/02 4/1/02 5/1/02 6/1/02 7/1/02 8/1/02 9/1/02 10/1/02 11/1/02 12/1/02 1/1/03 2/1/03 3/1/03 4/1/03 5/1/03 6/1/03 7/1/03 8/1/03 9/1/03 10/1/03 11/1/03 12/1/03 1/1/04 2/1/04 3/1/04 4/1/04 5/1/04 6/1/04 7/1/04 8/1/04 9/1/04 10/1/04 Delinquency % 1.13% 1.18% 1.40% 1.45% 1.57% 1.60% 1.66% 1.66% 1.66% 1.71% 1.72% 1.71% 1.70% 1.62% 1.66% 1.69% 1.67% 1.76% 1.78% 1.80% 1.81% 1.85% 1.87% 1.86% 1.90% 2.03% 2.01% 2.02% 2.03% 2.02% 1.96% 1.79% 1.77% 1.73% 1.58% 1.50% 1.46% 1.41% Non-Performing % 0.72% 0.75% 0.81% 0.82% 0.98% 1.06% 1.12% 1.23% 1.29% 1.29% 1.31% 1.27% 1.24% 1.22% 1.24% 1.23% 1.20% 1.21% 1.25% 1.26% 1.28% 1.40% 1.40% 1.40% 1.48% 1.47% 1.47% 1.49% 1.51% 1.50% 1.48% 1.41% 1.44% 1.35% 1.31% 1.20% 1.16% 1.10% Ratio 64.11% 63.47% 57.73% 56.55% 62.60% 66.34% 67.51% 73.73% 77.81% 75.51% 76.04% 74.44% 73.06% 75.39% 74.71% 73.16% 72.27% 68.93% 70.27% 70.13% 70.93% 75.70% 74.66% 75.29% 77.62% 72.25% 73.15% 73.94% 74.33% 74.05% 75.21% 78.47% 81.44% 78.31% 83.01% 79.70% 79.55% 78.10%

WINTER 2005

CMBS Collateral Performance (cont.)

Chart 3: CMSA Delinquency Status Codes

Chart 4: Delinquent Conduit Loans by ACLI Region

6.00% 5.00% Delinquency Rate 4.00% 3.00% 2.00% 1.00% 0.00% ENC ESC MID MTN NEW PAC SAT WNC WSC ACLI Region Source: Trepp, LLC 2003Q4 2004Q1 2004Q2 2004Q3

CMSA Code 0 - Current A - In Grace Period B - < 30 days 1 - 30-59 days 2 - 60-89 days 3 - 90+ days 4 - Performing, Post Balloon 5 - Non-Performing, Post Balloon 7 - In Foreclosure 9 - REO

Delinquent X X X X X X X

Non-Performing X X X X

Chart 5: Non-Performing Conduit Loans by ACLI Region

Region
2.50% 2003Q4 Delinquency Rate 2.00% 1.50% 1.00% 0.50% 0.00% ENC ESC MID MTN NEW ACLI Region Source: Trepp, LLC PAC SAT WNC WSC 2004Q1 2004Q2 2004Q3

Chart 6: Relative Performance by ACLI Region

2003Q4 Delinquency 0.99% 2.26% 4.24% 4.75% 2.37% 2.03% 3.17% 1.20% 1.97% 2.96% 2004Q3 Delinquency 0.65% 1.51% 2.89% 3.33% 1.70% 1.46% 2.44% 0.95% 1.02% 2.67% Ratio 66% 67% 68% 70% 72% 72% 77% 79% 79% 90%

Pacific New England West North Central East South Central Southern Atlantic National East North Central Middle Atlantic Mountain West South Central

Chart 7: Loan Delinquencies by CMSA Property Type

CMSA Property Type 9.00%

% of Balance Delinquent

50% 00% 50% 00% 50% 00% 2000:Q1 2002:Q3 2000:Q4 2003:Q2

8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

Source: Trepp, LLC

Non-performing loans also declined, continuing to follow the downward trend of overall delinquencies. The ratio of non-performing loans to delinquencies is relatively steady, indicating that the decline in delinquencies is part of a longer term cycle, rather than a short-term fluctuation in the statistics. Delinquency statistics are based on loan collateral supporting fixed-rate,
8 CMBS WORLD

conduit CMBS transactions, including "fusion" transactions. Chart 3 shows the mapping of CMSA Delinquency Status Codes to the various categories. All data is drawn from the Trepp CMBS Deal Library. Quarterly statistics are as of the last day of each calendar quarter.
(continued on p. 55)

CMBS Collateral Performance (cont.)

Chart 8: Delinquency by Year of Origination

9.00% 8.00%
% of Balance Delinquent

7.00% 6.00% 5.00% 4.00% 3.00 2.00 1.00 0.00

Source: Trepp, LLC

Chart 9: Non-Performing Loans by CMSA Property Type

CMSA Property Type 7.00%

% of Balance Non-Performing

00%

6.00% 5.00% 4.00% 00% 3.00% 2.00% 1.00% 0.00% 2000:Q1 2002:Q3 00% 2000:Q4 2003:Q2 50% 50%

Source: Trepp, LLC

Chart 10: Non-Performing Loans by Year of Origination

7.00%
% of Balance Non-Performing

6.00% 5.00% 4.00 3.00 2.00 1.00 0.00

Source: Trepp, LLC

WINTER 2005

CMBS INDEX RETURNS

Modest Performance in October

October 2004 index performance proved to be rather run-of-the-mill, with the investment-grade (IG) index outperforming swaps by 2 bp. Index spreads to swaps pretty much remained unchanged for AAAs, while mezzanine spreads moved a bit. Thanks to some more swap Barve spread tightening, the IG index managed to outperform Treasuries by 11 bp. Meanwhile, the rally in rates over the month ensured that total returns would remain well in positive territory; the IG index posted total returns of 83 bp. Within AAAs, locked-out classes performed better than current-payers, as they benefited more from the tightening in swap spreads. Current-pay classes posted excess returns of 4 bp versus Treasuries, while lockedout classes outperformed by 10 bp. Moving down the capital structure, mezzanine classes performed better than AAAs. However, performance among mezzanine classes was mixed. Single-As (which saw the most spread tightening) were the best

Neil Barve
performing investment-grade class, posting excess returns of 26 bp over Treasuries. BBBs, which have been the best performing IG class so far this year, trailed AAs and single-As in October, posting excess returns of 14 bp over Treasuries; spread widening ate away some of the carry advantage that BBBs hold. CMBS performance versus other benchmark sectors was mixed. Versus IG corporates, AA and single-A CMBS outperformed, while BBBs slightly underperformed. CMBS performance versus mortgages was noticeably poor. Versus MBS, current-pay and locked-out AAAs underperformed by 26 bp and 23 bp, respectively. Mortgages fared well in October, as they saw muted prepayment activity and meaningful spread tightening. Meanwhile, CMBS performance versus agency debentures was not much better. Current-pay and locked-out AAAs underperformed by 17 bp and 25 bp, respectively, on a duration-adjusted basis. After cheapening due to headline risk in September, spreads on agency debentures recovered in October.

Neil Barve is in CMBS Research at Lehman Brothers, Inc.

Chart 1: CMBS Index Performance October, in basis points

XS Returns vs. Treasuries Jul-04 10 4 10 11 15 26 14 37 30 YTD-04 78 55 79 86 102 119 281 1171 1162 -60 675 XS Returns vs. Swaps Jul-04 1 -1 1 2 6 16 5 YTD-04 56 22 56 62 84 99 254 8 6 -1 41 17 126 -26/-17 -23/-25 1/7 4/1 XS Returns vs. Corporates a Jul-04 YTD-04 XS Returns vs. MBS/Agencies b Jul-04 YTD-04 CMBS Spread Changec Jul-04 -1 0 -1 -1 -2 -3 -1 4 0 YTD-04 -2 0 -2 -2 -6 -5 -29 -133 -118

Total Returns Index U.S. Agg. Component d Aaa - Current Pay Aaa - Locked Out Inv. Grade Aa A Baa High Yield Ba Jul-04 81 57 87 83 94 106 96 121 116 YTD-04 430 305 460 447 501 528 706 1611 1612

a)Excess returns over comparable High Grade or High Yield Corporate securities, adjusted for duration and spread duration. b) Includes only non-callable securities in the Agency index. c) Over Treasuries; as measured by the average of the index. d) Lehman Aggregate Index currently includes ERISA-eligible classes only.

10 CMBS WORLD

CALENDAR OF EVENTS
CMSA Events

6/8-10/2005 10/17-18/2005

Eleventh Annual Convention NY Marriott Marquis New York, NY 2005 European CMSA Conference Conrad Hilton Brussels, Belgium

10/24-25/2005 1/8-10/2006

2005 Canadian Conference Hilton Toronto Toronto, Ontario CMBS Investors Conference Boca Raton Resort & Club Boca Raton, FL

Look for an upcoming CMBS 101 Seminar in a city near you this Spring. Check our website, www.cmbs.org, for updated information.

Other Industry Events

1/18-20/2005 1/19-21/2005 1/23-26/2005 1/27-28/2005 2/6-9/2005 3/10-11/2005 4/27-29/2005
NAIOP Real Estate Capital Markets Conference New York, NY NMHC Annual Meeting La Quinta, CA ASF 2005 Conference Scottsdale, AZ RER State of the Industry Washington, D.C. MBA CREF Multifamily Housing Expo San Diego, CA PREA Spring Conference Chicago, IL ULI Spring Council Forum San Antonio, CA

5/4-6/2005 5/19-20/2005 5/22-25/2005 6/16-17/2005 9/28-10/1/2005 10/18-21/2005 11/2-4/2005

MBA Commercial Asset Administration & Technology Conference Chicago, IL ALI ABA Commercial Securitization for Real Estate Lawyers Chicago, IL ICSC Spring Convention Las Vegas, NV RER Annual Meeting Washington, D.C. CREW-Network Annual Convention Seattle, WA 2005 NAIOP Annual Conference Hollywood, FL NAREIT Annual Convention Chicago, IL

Check our website, www.cmbs.org, for updates, as well as more Roundtable and International Chapter events! For further information, please contact CMSA at (212) 509-1844 or info@cmbs.org.

WINTER 2005

11

12 CMBS WORLD

Conduit CMBS Balloon Risk in a Rising Rate Environment

Peter Rubinstein and Alan Todd
A look at the Table of Contents for this issue of CMBS World makes it clear that lately nearly everyone has become concerned about loan quality in commercial mortgagebacked securities (CMBS). One particular concern, well articulated by Larry Duggins of ARCap (see p. Rubinstein 16), is that conduit loans made at todays low rates carry more balloon risk than in the past because refinancing rates will surely be higher in the future. A number of counter arguments have emerged, several of which are well covered by Moodys analysts Paul Staples and Sally Gordon (see p. 37). In this Todd article, we suggest another mitigant that (we suspect) is not well appreciated in the marketplace. We submit that the near universal use of lockout and defeasance structures will reduce balloon risk if interest rates rise over the next few years. Why? Although we have not seen this tested yet, theory suggests that a jump in rates will create a powerful incentive for borrowers to prepay through defeasance long before the loans reach maturity, each time leaving the investor with a loan backed by Treasuries instead of real estate. To the extent this occurs, it eliminates balloon risk, and further, it has direct implications for the valuation of subordinate bonds, leveraged IOs, and current-pay bonds.
TM

prepayment penalty structure called yield maintenance. Under this design, borrowers are allowed to prepay freely after lockout, but the payoff amount must equal the present value of the remaining cash flows discounted at market rates at the time of prepayment, where the term market rate is typically defined as Treasuries flat. Since these loans (particularly in the mid- to late 1990s) were generally issued with coupons of more than 200 basis points over Treasuries, the total payoff could easily exceed par by a wide margin. In addition, to prevent payoffs below par (which could in theory occur if a borrower decided to prepay when Treasury rates were well above the loan coupon rate), yield maintenance loans are structured with a minimum payoff requirement of par plus a fee of, typically, at least 1%.

FAST FORWARD

TO

MODERN TIMES

A BRIEF HISTORY

OF

CONDUIT LOAN DESIGN

To see why, we need to briefly review the design of fixed-rate conduit loans. Its well known that virtually all conduit loans have a hard lockout that forbids prepayment over the first two to five years of a loans life and, similarly, that most loans offer borrowers the right to freely prepay without penalty during the last few months of a loans life, but in between, there can be a world of difference. The first conduit loans, those issued in the early- to mid-1990s, had set prepayment penalty schedules which mandated exactly how much extra a borrower had to pay to retire a loan at any point in time between the lockout and the open period. Under this structure, the penalty has no connection to the interest rates in effect at the time of prepayment. A few years later, the market corrected this lack of a connection by shifting to a

In the mid- to late 1990s, somebody, in a flash of brilliance, realized that there was a better way to design conduit loans: better for investors and, once you think about it, better for borrowers, too. The new design, called lockout and defeasance, now dominates the conduit market by a wide margin, with more than a 90% market share. The key innovation with this design is that technically, the borrower can never prepay before the beginning of the open period. They can, however, achieve the same effect (i.e., remove the mortgage lien encumbering their property and extinguish their obligation under the note) at any time after the hard lockout expires by simply securing the loan with alternative collateral capable of paying off the obligation under the note. To guarantee that the alternative collateral can actually perform, Treasuries securities are the only acceptable alternative.1

IMPACT ON BORROWER PREPAYMENT BEHAVIOR IMPLICATIONS FOR INVESTORS

AND

As with yield maintenance, defeasance can be expensive (when rates are low), but overall it is still the best alternative for borrowers because there is no minimum penalty and no minimum payoff amount. Under older style loans, the borrower always has to pay more than par to prepay before the beginning of the open period. With lockout and defeasance, the borrower simply presents acceptable alternative collateral regardless of what it actually costs the borrower to get the collateral. If Treasury rates happen to be high in relation to the coupon
WINTER 2005 13

Conduit CMBS Balloon Risk in a Rising Rate Environment

(cont.)

Chart 1: Incentive to Defease

Chart 2: Loans Defeased

Vintage

10 8
Benefit (Millions of Dollars)

1995 1996 1997 1998 1999 2000 2001 2002

Number Defeased Current Balance Number Defeased Current Balance Number Defeased Current Balance Number Defeased Current Balance Number Defeased Current Balance Number Defeased Current Balance Number Defeased Current Balance Number Defeased Current Balance Total Number Defeased Total Securitized Balance

6 26,150,084 34 199,751,239 69 569,325,902 273 1,683,713,670 238 1,260,477,369 123 705,972,022 48 637,340,929 11 72,985,789 802 5,155,717,003

6 4 2 0 (2) (4) (6) (8) (10)

0. 0% 0. 5% 1. 0% 1. 5% 2. 0% 2. 5% 3. 0% 3. 5% 4. 0% 4. 5% 5. 0% 5. 5% 6. 0% 6. 5% 7. 0% 7. 5% 8. 0% 8. 5% 9. 0% 9. 5% 10 .0 %

Treasury Rates

Source: Bear Stearns

on the loan at the time of defeasance, the borrower can defease for an amount that may be significantly less than par. So under this design (and unlike normal prepayment behavior), when interest rates go up there is an economic incentive for borrowers to prepay through defeasance. In terms of financial theory, under this design the strike price on the borrowers call option changes (inversely) with market interest rates. This, of course, also means that the borrower has a disincentive to defease if rates go down (as with yield maintenance), unless, of course, rate changes have been offset by a significant decline in lending spreads.

Source: Trepp, LLC

HOW BIG

OF AN

EFFECT COULD THIS HAVE?

To appreciate the potential significance of this effect, consider first the following micro-level example based on real data. The setting is late spring 2003, when Treasury rates fell to 40-year lows, sparking a surge in loan demand. With the 10-year Treasury hovering near 3%, and with competition tightening borrower spreads, hundreds of millions of dollars of conduit loans were issued with coupons in the mid-4% and even the low-to-mid-3% range, the lowest coupons on record for conduit CMBS. Now imagine that one of these mortgages is yours, the one on 17 Battery Place, a New York City office building. The loan was originally for $60.5 million and was securitized in JPMCC 2003-PM1. It was closed on June 30, 2003, had a first pay date of August 1, 2003, and a fixed coupon of 4.58%, set to amortize over 30 years, but with a balloon payment due in five years. In terms of prepayment restrictions, the loan originally had two years of hard lockout followed by 33 months during which time defeasance is allowed. Now fast forward to July of 2005. The lockout is off, so you, the borrower, have a decision: to defease or not to defease. Assume that rates have (finally) risen substantially and further, assume for convenience that the curve has
14 CMBS WORLD

flattened, as is common in a rising rate environment. The balance at this point in time after making 24 payments will be $58,618,563.99, leaving 36 more payments of $309,427.13 plus a balloon payment of $55,443,060.43 due at the time of the last monthly payment. Assuming for convenience that the yield curve is flat, the cost of defeasing and therefore the benefit (which is the current balance due less the cost to defease), is easy to calculate for any interest rate.2 We show the benefit in Chart 1 as a function of interest rates. The breakeven Treasury rate is only 4.65%, and at higher rates the benefit of defeasing moves up, easily running into the millions of dollars even at rates as low as 6%, a common level only a few years ago. And note that this gain has the potential advantage of not being taxed immediately, although this means that over the remaining term of the loan there will be a surplus of interest collected on the defeasing Treasury portfolio over the interest paid on the loan defeased. This will be picked up as taxable income in each year (a complete discussion of the tax issues involved is beyond the scope of this article). What this example shows is that a borrower has a stronger and stronger incentive to defease as rates go up, but one example does not make a general case. If we step back, however, to a more macro-level and examine the overall size of the market for loans like this, we find it is significant. Looking at all conduit loans within our database securitized during the last three quarters of 2003, we find over $886 million have rates at or below 4%, and over $2.9 billion have rates at or below the 4.58% rate used in our example loan, and a total of more than $8.6 billion have rates at or below 5%. This is a sizable cohort, and the

Conduit CMBS Balloon Risk in a Rising Rate Environment

(cont.)

vast majority of these use a lockout and defeasance design. Most are above average in size, which means that the fixed transaction costs involved in defeasance should not be restrictive. Further, based on data from Trepp, LLC, there is clear evidence that many borrowers defease loans even when it costs more than the loan amount to do so. Trepp has identified over 800 loans from the 1994 through 2002 vintages, totaling over $5.1 billion, that have defeased, and the true number is surely higher because trustee statements and tapes do not always explicitly identify loans that have been defeased (see Chart 2).

likely to be defeased because of the economic benefits. All of the other reasons borrowers already have for prepaying and/or defeasing are simply enhanced with a low coupon loan, and the data from Trepp LLC, shown in Chart 2, indicates that borrowers have already been defeasing loans even without the savings we have identified. Why? One motivation is to sell the building to take a profit. Another common reason is to take out cash by re-leveraging the property. Other reasons surely exist, but regardless of the cause, the motivation is greater with low coupon loans once rates rise. Which bonds would benefit most from a wave of defeasance? Clearly the more credit sensitive securities benefit because every dollar defeased is a dollar that cant default. Of course the same is true for yield maintenance loans that prepay since a loan that prepays cant default, but there is no economic incentive in a high rate environment for yield maintenance loans to prepay: they always have an above par minimum payoff requirement. Leveraged (i.e., non-call protected) IOs also benefit since defeasance lowers the risk from default induced prepayments and losses, and similarly, the benefit extends to premium first pay bonds since they bear the brunt of default induced prepayments.
(continued on p. 56)

WHAT DOES THIS MEAN

FOR INVESTORS?

The lockout and defeasance design already offers two key advantages to investors. First, regardless of the level of defeasance, the investor still gets virtually all of the originally promised cash flows.3 In other words, the cash flows are positively convex. Second, to the extent loans defease, the risk profile of the pool improves because the loans, which are rarely rated above triple-B, are replaced with Treasury securities. It is the second of these benefits that is enhanced in pools that are backed by low coupon collateral. The reason is very simple. Holding all else constant, we have shown that low coupon loans are more

WINTER 2005

15

The Pool Refinance Loss Factor

Larry Duggins
Over the past six years, ARCap has consistently applied the same cash flow-based loss methodology to its commercial mortgage-backed securities (CMBS) pool selection and investment decisions. In 2004, that methodology has revealed a startling increase in risk associated Duggins with balloon maturities. A meaningful number of CMBS mortgages being originated today cannot refinance at maturity, if Treasury rates return to their 10-year averages and mortgage spreads return to their 5-year averages. This article discusses the underpinnings of ARCaps loss methodology, examines its recent findings, and finally, proposes the use of the Pool Refinance Loss Factor (PRLF) as a standard component of investment-grade CMBS pool evaluation. Loss estimation is a central component in the evaluation of below-investment-grade CMBS investments. Each B-piece investor develops a loss estimation methodology which in turn guides its real estate due diligence process. Some investors focus on the growth of collateral value over time with an emphasis on market conditions and cap rates, while others focus on property level cash flows and the ability of the property to refinance its mortgage at maturity. The loss estimation methodology allows the B-piece investor to project the timing and severity of potential losses in the mortgage pool, which in turn allows the analysis of potential returns for the non-investment-grade bonds themselves. Since its inception, ARCap has focused on cash flow rather than value estimation as the basis for its evaluation of potential losses in CMBS pools. This bias stems from our conviction that cash flow methodologies are more theoretically sound from a real estate perspective because they are directly rooted in the analysis of the operations of the individual collateral properties. Valuebased loss methodologies begin with cash flow analysis but then introduce cap rate factors which, for many of the small markets in which CMBS loans are originated, are nothing more than educated guesses by due diligence reviewers. By focusing on the ability of a property to generate sufficient cash flow to refinance its mortgage
16 CMBS WORLD

Loss estimation is a central component in the

given foreseeable market conditions, the B-piece investor can analyze property performance and relate it directly to mortgage performance and loss estimates.

It has become industry practice to provide potential Bpiece investors with indicative data tapes approximately six weeks prior to the public launch of a CMBS pool. The potential high yield investors review this preliminary data approximately the same information that will ultimately end up in Annex A of the prospectus supplement issued in connection with the sale of the CMBS to form indicative bids for the noninvestment-grade bonds. ARCap developed an Excelbased model that utilizes the information on the indicative data tape to estimate the potential performance of each mortgage. ARCaps analysis begins with the issuers assessment of normalized net cash flow for each property. Cash flow available for debt service is calculated by dividing the normalized net cash flow by a market level, propertytype specific debt service coverage ratio. We then calculate a refinance interest rate equal to the sum of a benchmark rate of the 10-year average of the 10-year U.S. Treasury bond at the time of the analysis plus the spread which we calculate using the 5-year average of spreads for similar properties in our portfolio. The refinance interest rate calculation is intended to reflect average market conditions as opposed to peaks or troughs in the Treasury or mortgage markets. We then determine a refinance amortization term based on the age and condition of the property. Generally speaking, the model uses a 30-year amortization term for assets younger than 30 years old, and a half-life amortization for properties that are older. The half-life amortization is calculated by subtracting one half of the initial loan term from the initial loan amortization, i.e. a 10-year loan with a 30-year original amortization would have a 25-year refinance amortization. Using the cash flow, the rate and the amortization term, we then calculate a hypothetical refinance

The Pool Refinance Loss Factor (cont.)

Chart 1: PRLF Methodology Flow Chart

Commercial Mortgage Loan

Property Net Cash Flow

Property Type

Year of Property Construction

Maturity Balance

Normalized Net Cash Flow

Property Type DSCR

Amortization Schedule Based on Property Age

Benchmark Rate: 10-Year Average of 10-Year Treasury

Spread: 5-Year Average of Spreads for Similar Properties

Maximum Monthly Debt Service Payment of Refinance

Refinance Amortization

Refinance Interest Rate

Maximum Reference Loan Amount

Maximum Reference Loan Amount

Maturity Balance

Potential Refinance Loss LOSS

NO Loss of Refinance? LOSS

Maximum Refinance Loan Amount

>

Maturity Balance

Swept Loss Assume Borrower Will Protect Equity

Maturity Balance

4 Months of Servicer Advancing with Interest

Adjusted Maturity Balance (with loss)

Refinance Loss Assume Borrower Will Default

Calculate Pool Refinance Loss Percentage Sum of Shortfalls Greater Than 7.5% of Maturity Balance

Maximum Refinance Loan Amount

Maximum Refinance Loan Amount

Adjusted Maturity Balance (with loss)

Shortfall Percentage?

Adjusted Maturity Balance (with loss)

Cut-Off Pool Balance

Shortfall within 7.5% of Maturity Balance

Shortfall Greater Than 7.5% of Maturity Balance

Pool Refinance Loss Percentage

Source: ARCap REIT, Inc.

amount for each loan which is compared to the loan balance at the test date (usually loan maturity). If the refinance amount exceeds the loan balance at the test date, we assume there is no loss on that loan. If the refinance amount is less than the balance at the test date, we assume that the servicer advances for four payments and then liquidates the loan at the refinance amount, with the difference being recognized as a loss. If the refinance amount is less than the balance at the test date, but the shortfall is within 7.5% of the original balance, we remove the loss from the calculation based on the assumption that the borrower will protect his equity at that time.

The remaining losses generated by each loan are then totaled to calculate the percentage of the total pool which we anticipate losing at refinance. This methodology yields a single data point, the PRLF, which measures the relative refinance risk of two or more pools. Additionally, we run sensitivity analyses in which we reduce the issuers cash flow by 5% and 7.5%, which obviously increases the loss percentage. Essentially, the model tests the ability of properties to refinance their associated mortgages if Treasury rates and mortgage spreads revert to the mean. The model assumes that cash flows are normalized and remain constant, recognizing neither revenue growth nor expense inflation over time.
WINTER 2005 17

The Pool Refinance Loss Factor (cont.)

Chart 2: PRLF for Q1-Q3 2004 CMBS Conduit Transactions

0.06

0.05 Pool Refinance Loss Factor

0.04

0.03

0.02

0.01

0
4 8 4 1 3 8 1 2 1 9 1 1 5 2 7 3 2 1 2 4 3 2 1 1 -2 -1 4 2 Y2 3 0 1 2 3 6 -3 1 1 A A 2 -T1 -IQ WR 4-C -T1 -CB 4-C -T1 4-C -IQ WR 4-C NC -CB 4-C 4-C 4-C -LN -GG -GG 4-C 4-C KB 4-C 04 04 4-C 4-C KE -HQ 4-C -C1 -C1 4-C 4-C 04 4-C 4-C B3 B2 -C1 04 004 4-P 00 004 04 00 004 00 004 4-P 00 4-P 04 00 00 00 004 04 04 00 00 4-M 00 20 20 00 00 04- 04 00 04 04 00 00 20 00 00 04-L 04-L 04 2 00 B 2 2 20 C 2 2 C 2 2 00 B 2 00 20 S 2 C 2 B 2 2 20 20 C 2 C 2 00 T 2 M M S 2 C 2 20 20 S 2 20 20 T 2 S 2 M C 2 S 2 20 20 20 S SC 2 T T T M B AC C M S 2 C B M S SC C C SC C SC 2 S C C B S M M 2 M AC AC B C T C CM M MS CF M MC JPM M JPM M MS CF CC MC LBU EC CF PMC CCF SM EC EC MT BC B B LBU MA LM MS LBU BCM BCM GC LBU B MA GS MM MM BCM C G G L W G M G G G O CO W C C J G BS JP PM JP W W S S C M J B B 20

Sources: Trepp, LLC; Bloomberg; ARCap REIT, Inc.

Chart 3: PRLF and AAA Subordination Levels for Q1-Q3 2004 CMBS Conduit Transactions

0.17 0.16 0.15 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0
2 3 2 3 2 1 1 -2 -1 4 2 3 2 1 2 4 4 0 1 6 -3 1 1 A A 2 8 4 2 1 9 1 1 3 5 2 7 1 3 8 1 -T1 -IQ WR 4-C -T1 -CB 4-C -T1 4-C -IQ WR 4-C NC -CB 4-C 4-C 4-C -LN -GG -GG 4-C 4-C KB 4-C 04 04 4-C 4-C EY -HQ 4-C -C1 -C1 4-C 4-C 04 4-C 4-C B3 B2 -C1 04 004 4-P 00 004 04 00 004 00 004 4-P 00 4-P 04 00 00 00 004 04 04 00 00 4-M 00 20 20 00 00 4-K 04 00 04 04 00 00 20 00 00 04-L 04-L 04 0 2 2 2 2 0 2 2 2 2 0 2 2 2 0 2 2 2 2 2 2 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 S SC 20 SB SC C 2 CC SC CC SC 20 SB 20 C 2 BS MC SB C 2 C 2 S 2 MC MC 20 MT ACM ACM BS CC 20 C 2 BS T 2 T 2 MT BS ACM CC MS 20 20 T 2 CM M MS CF M MC JPM M JPM M MS CF CC MC LBU EC CF PMC CCF SM EC EC MT BC B B LBU MA LMT MS LBU BCM BCM GC LBU B MA GS MM MM BCM S C G L W G G M G M JP G G C C J G B JP W W CO CO W M JP BS BS

Pool Refinance Loss Factor

Subordination % to AAA at Issuance

Sources: Trepp, LLC; Bloomberg; ARCap REIT, Inc.

A confluence of factors occurred in 2004 that has resulted in the origination of a significant number of high leverage loans with low coupons and minimal reserves. Competition among mortgage originators is fierce, with competitive pressures adversely affecting credit quality. In addition, the rating agencies have moved to bring ratings parity to fixed income products, thereby reducing subordination levels. Finally, B-piece
18 CMBS WORLD

investor competition has dramatically increased, reducing the ability of individual B-piece investors to influence credit standards. The PRLF clearly illustrates the impact of this deterioration of credit standards. Chart 2 illustrates the PRLF for CMBS issues placed during the first three quarters of 2004. The outcomes range from a low of 0% for the BSCMS 2004-TOP14 to

The Pool Refinance Loss Factor (cont.)

A review of the outcomes for the first three quarters of 2004 . . . seems to imply that

5.23% for the WBCMT 2004-C12. The PRLF indicates that the risk of refinance loss in the WBCMT 2004-C12 is substantially greater that of the BSCMS 2004-TOP14. Of course, additional due diligence would be necessary to incorporate other factors which might reduce the projected loss for WBCMT 2004-C12 or increase the projected loss for BSCMS 2004-TOP14 before an actual investment decision was made. It is critical to recognize that the PRLF only addresses refinancing risks and does not incorporate other elements of credit risk. A pool with a low PRLF may have other serious credit-related issues and vice versa.

associated with CMBS, increasing the amplitude of future real estate cycles with CMBS investors taking the brunt of the losses. However, by using simple tools like the Pool Refinance Loss Factor to uncover hidden risks, investment-grade investors can direct the fundamental credit quality in CMBS, reintroducing adherence to common sense underwriting. Mortgage originators, reacting as they must to their competitive environment, are driven to reflect the minimum standards of the investment community. Their borrower-clients will absorb as many concessions as they are offered until they are stopped by the investors who are the ultimate owners of their mortgages. It is time for investmentgrade CMBS investors to raise the bar.

A comparison of the AAA subordination levels for those issues indicates 12.13% for the BSCMS 2004TOP14 and 13.38% for the WBCMT 2004-C12, which does not seem to be an adequate recognition of the additional refinance risk. Chart 3 further illustrates this observation by overlaying AAA subordination levels on the PRLF data from Chart 2. The expected outcome of increased subordination levels for pools with greater refinance risk does not occur. More CMBS issues will have to pass through their complete life cycles to generate a data set that is sufficiently complete to empirically test the statistical predictive value of the PRLF. A review of the outcomes for the first three quarters of 2004, however, seems to imply that significant refinance risks are not being addressed in AAA subordination levels. Further, this predictive tool is indicating the possibility of pool losses substantially higher than those implied by the widely circulated historical default and loss severity studies. Investment-grade CMBS investors can easily implement the tool as one of their evaluation criteria in their discussions of CMBS offerings. Our conclusion is caveat emptor. Investment-grade CMBS investors can never forget that mortgages and real estate support the bonds in which they invest. Such investors are ultimately responsible for maintaining the credit quality of their investments by rejecting the offerings of issuers whose aggressive lending approach may adversely affect that credit quality. That responsibility cannot be shirked to the ratings agencies or the B-piece investors, who each face their own competitive dynamics. The combination of unrestrained competition and declining subordination could meaningfully reduce the real estate market discipline

Larry Duggins is President and Chief Operating Officer of ARCap REIT, Inc. The author gives special thanks to Timothy Riddiough, Ph.D., E.J. Plesko Chair of Real Estate and Urban Land Economics, University of Wisconsin, for his comments; and Kyle McGlothlin, Steve Carnes and Ryan Stephens of ARCap for their analytical contributions. ARCaps Pool Refinance Loss Factor model may be downloaded without charge from www.arcap.com.

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19

20 CMBS WORLD

Commercial Mortgage Defaults: 30 Years of History

Howard Esaki and Masumi Goldman
In this paper, we extended our series of commercial mortgage default studies to include data through 2002. Our main conclusion is that most investment-grade CMBS (with the exception of BBBs from more recent vintages) are well protected against the most severe real estate downturn of the last 30 years.

With continued reductions in subordination levels, a greater proportion of recently rated BBB classes
BACKGROUND

Esaki

The new study covers the time period 1972-2002. The addition of two years of new data alters the original conclusion only slightly. In the past, all investment-grade commercial mortgage-backed securities (CMBS) were protected from Goldman the magnitude of losses experienced by life insurance company loans. With continued reductions in subordination levels, a greater proportion of recently rated BBB classes would now be vulnerable to a downturn of the magnitude of the late 1980s and early 1990s. In our updated study: We added 1,383 new loans, increasing the total to nearly 18,000. The average lifetime cumulative default rate (based on loan balances) for cohorts with at least ten years of seasoning decreased from 20.5% to 19.6% over the last two years. 1986 remained the worst origination year, with nearly 32% of the total balance eventually defaulting. The average severity on liquidated loans was about 33%. Of the cohorts with at least ten years of seasoning, the 1991 and 1992 origination years had the lowest cumulative default rates. For a given cohort, on average, the peak years for defaults were years three through seven after origination. About 55% of the defaulted loans were liquidated.

Mark Snyderman authored two pioneering studies in 1991 and 19941 on cumulative lifetime default rates on commercial mortgages held by life insurance companies. His 1994 article tracked defaults (90+ day delinquent loans) on eight large insurance companies through 1991. The studies were the first to track commercial mortgage credit through several complete real estate cycles. Snyderman was able to follow the performance of loans originated in a given year (cohort) until all of the loans had either matured, prepaid or defaulted. In 1999, Snyderman, Steven LHeureux and Howard Esaki (collectively, ELS) used the same insurance companies and data sources as the original studies to update the default data through 1997.2 The period of the ELS extension included the final years of the worst real estate downturn since the Great Depression of the 1930s. One of the findings of the study was that the 1986 cohort of originations was the worst in the past 30 years, with a cumulative default rate of 28%. Investment-grade CMBS from the average conduit deal issued at that time, however, would not have lost principal if subjected to the default and loss rates experienced by the 1986 cohort. In 2002, Esaki updated the study, adding three years of data.3 The main finding was that declining subordination levels would put some BBB CMBS at risk if the default rates of the worst cohort were repeated.

COMPARISON

TO

PREVIOUS STUDIES

Our update through 2002 shows little difference from the results of the previous study with data through 2000. Only 21 loans from the database defaulted during 2001 and 2002. This represents only 0.3% of the total number of loans originated in the last ten years of the study In the current update, we examined the credit performance of 17,978 individual loans, an increase of about 1,400 loans from the 2002 study. The average
WINTER 2005 21

Commercial Mortgage Defaults: 30 Years of History (cont.)

Chart 1: Severity of Loss on Liquidated Loans 1992-2002

125% 100% 100% 75% 50% 25% 0% -25% -50% -40% Principal Amount Owed

The cumulative default rate of almost 32% for originations in 1986

109% Loss-31% Recovery 69%

Property Revenue and Property Sale Proceeds

Expenses-17% Foregone Interest-23%

for 2001 and 2002. We then aggregated our data with the two previous Snyderman studies, the ELS findings, and the 2002 Esaki report. As in the earlier studies, we chose to include cohorts with a minimum of five years of seasoning. Of the 17,978 total loans originated, about 2,700 (15.3%), had defaulted by 2002.

SIZE OF LOANS
The median loan size was about $4.2 million, and the average loan size was about $8.5 million. Average loan size has trended up over time, increasing from $3 million in 1972 to $14 million in 1997. Over 70% of the loans were less than $8 million. The less-than-$2 million loan category had the lowest default rate, while the $4-$8 million category had the highest default rate. This is the same as previous studies.

Source: Morgan Stanley

Chart 2: Average Subordination for Conduit/Fusion Transactions

1998 AAA AA A BBB BB B 29% 24% 18% 13% 6% 3% 1999 27% 22% 17% 12% 6% 3% 2000 23% 19% 14% 11% 5% 3% 2001 21% 17% 13% 9% 4% 2% 2002 20% 16% 12% 8% 4% 2% 2003 17% 14% 10% 7% 3% 2% 2004a 14% 12% 9% 5% 3% 2%

GEOGRAPHIC DISTRIBUTION
As in earlier studies, the loans are geographically well diversified, with the largest percentages in the West (23%) and Northeast (22%). The highest default rates were in the South Central region (25%), with the lowest in the West (10%).

a As of August 19, 2004 Sources: Commercial Mortgage Alert, Morgan Stanley

Chart 3: Number of Loans by Originator1972-1997

Percentage Number Change from of Loans Esaki (2002) 3,042 1,062 1,838 2,538 1,736 1,108 4,349 2,305 17,978 1.1% 15.9% 1.1% 13.0% 25.0% 21.9% 7.6% 1.7% 8.3% Total Loan Amount ($bil) 26.6 5.7 17.2 18.1 11.5 13.6 42.6 17.4 152.8

DEFAULTS BY ORIGINATION COHORT

The cumulative lifetime default rate (by loan balance) for cohorts with at least ten years of history ranged from 4.0% for 1992 originations to 31.7% for 1986 originations. The average lifetime cumulative default rate (based on loan balance) for cohorts with at least ten years of seasoning was 19.6%, down from 20.5% in the previous study. The drop resulted from the addition of 1991 and 1992, which had the two lowest cumulative default rates of any cohort.

Originator Aetna Life Insurance Company Connecticut Mutual Life Insurance Company Equitable Life Insurance Company John Hancock Mutual Life Insurance Company New England Mutual Life Insurance Company The Northwestern Mutual Life Insurance Company The Prudential Insurance Company of America The Travelers Insurance Company Total
Source: Morgan Stanley

TIMING OF DEFAULTS
On average, the annual default rate was low within the year of loan origination, rose to about 1% in the first year following origination, then jumped to a range of 1.5% to 2.7% for the next six years. Default rates then declined to less than 1% for the next three years, and tailed off gradually. These results are nearly identical to the 2002 Esaki study. As in that study, there is no spike in defaults at balloon dates. Some research analysts have noted that loan restructures result in the appearance of low default rates in balloon years, but there is no evidence to support this in our study. The default timing pattern for individual cohorts can vary widely from the average. The timing and total defaults of a cohort are highly dependent on its position in the real estate cycle. For almost all cohorts, however, the peak in defaults is in years three through seven after origination.

lifetime cumulative default rate for origination cohorts with at least ten years of history was 19.6%, slightly lower than the 20.5% in the prior default study published by Esaki in 2002. On average, about 91% of defaults occurred within the first ten years of origination. The cumulative default rate of almost 32% for originations in 1986 was again the highest for any cohort.

NUMBER OF LOANS BY ORIGINATOR AND ORIGINATION YEAR

In the current study, we tracked commercial mortgage default rates from life insurance company annual statements
22 CMBS WORLD

Commercial Mortgage Defaults: 30 Years of History (cont.)

Chart 4: Number of Loans by Origination Year

Chart 5: Average Loan Amount by Origination Year

Count 1400 1249 1200 1000 800 736 706 708 600 533 400 200 0 1972 1977 1982 1987 1992 1997 1055 1125

($mm) 15 11.1 12.0 13.0 12.1 11.3 9.7 10.1 10.6 11.9 12.1 13.8 14.1 1987 1992 1997

1017 959 1017 863

10 734 416 320 482 467 563 623 735 8.4

10.7 1972 3.3 3.5 3.4 4.1 4.8 5.0 3.8 4.0 5.2 1977

844

638 567

515 487

401

218

0 1982

Source: Morgan Stanley

Source: Morgan Stanley

Chart 6: Loans Originated and Default Rates by Principal Amount

Percentage Change from Esaki (2002) 3.3% 5.2% 9.8% 14.5% 8.3% Percent of Total 22.7% 24.9% 24.1% 28.3% 100.0% Loan Count Default Rate 12.9% 15.6% 16.7% 15.7% 15.3%

Loan Amount 1-2 MM 2-4 MM 4-8 MM >8 MM Total

Loans Originated 4,083 4,473 4,326 5,096 17,978

The timing and total defaults of a cohort are

7.1

7.1

9.1

Source: Morgan Stanley

In Chart 1, we outline the components that are used in the loss severity calculation. For loans that were liquidated within the last ten years of the study, foregone interest accounted for a large portion of loss severity. On average, the loans liquidated within this 10-year time period experienced 24 months between default and liquidation.

LIQUIDATIONS

AND

RECOVERIES

As in previous studies, not all defaulting (90+ days delinquent) loans liquidate. We found that only about half of the loans we recorded as entering default for the first time went straight through to liquidation. Another quarter of the loans were restructured, while the rest became current again. Of the loans becoming current, about 60% were eventually restructured, and another 30% defaulted again. We estimate that about 55% of loans entering default are eventually liquidated, 40% are restructured, 3% become delinquent again, and only 2% fully recover. Our finding that 20% of loans entering default initially recover is similar to a 2001 FitchRatings CMBS default study4 finding that 22% of defaulted loans in CMBS return to current status. Our study goes one step further, however, and finds that only about 9% of these loans remain current. This means that only about 2% (20% x 9%) of loans entering default return permanently to current status.

For the entire 1972-2002 period, the average severity of loss on foreclosed loans is about 33%. As in earlier studies, the range of severities for individual loans is large. Some loans had severities of over 100%, while others recorded no loss.

IMPACTS

OF

DEFAULTS

ON

CURRENT BOND STRUCTURES

In the 2002 Esaki study, we found that the average cohort with at least ten years of seasoning lost about 5.4% of its original balance through defaults. In this study, the average cohort with at least ten years of seasoning lost slightly less, about 4.9% of its original balance. This calculation assumes that restructured loans have half of the severity (16.5%) of liquidated loans. Since the average conduit/fusion transaction today is being issued with BBB subordination levels of about 5%, most investment-grade CMBS are still protected against the average loss of origination cohorts of the last 30 years. The loss on the worst cohort, 1986, has an estimated loss of 8.1% of its original balance. This exceeds the average BBB subordination level on conduit and fusion CMBS transactions being issued today, and would result in the default of even some single-A classes. It is, however, still below the lowest credit support levels for AAA CMBS.
WINTER 2005 23

SEVERITY

OF

LOSS

The loss severity on liquidated loans for the loans added to the previous study was about 31%, the same as in the previous study and less than the 36% in the original Snyderman studies. The severity calculation includes foregone interest and expenses, as well as lost principal.

Commercial Mortgage Defaults: 30 Years of History (cont.)

Chart 7: Loans Originated and Default Rates by Region

By Loan Count Number of Loans West Coast South Central Northeast Mid-Central Southeast Canada/Other Total
Source: Morgan Stanley

By Loan Amount Percent of Total 24.2 12.8 26.3 16.7 17.9 2.1 100.0 Percentage Change -0.4 0.2 -0.4 0.0 0.5 0.1 N/A Default Rate (%) 11.6 23.7 13.9 16.6 14.4 15.7 15.2

Percentage Change from Esaki (2002) 9.2 7.3 6.7 8.0 8.8 20.9 8.3

Amount of Loans ($bil) 37.0 19.6 40.1 25.4 27.4 3.3 152.8

Percent of Total 22.9 16.9 21.6 18.5 17.1 3.0 100.0

Percentage Change from Esaki (2002) 0.2 -0.2 -0.3 0.0 0.1 0.3 N/A

Default 10.2 24.6 13.3 15.8 15.7 9.8 15.3

4,120 3,042 3,891 3,317 3,069 539 17,978

Chart 8: Lifetime Default Rates by Origination Cohort (by Principal Balance)

Chart 9: Lifetime Default Rates by Origination Cohort (by Loan Count)

(%) 35 30 25 20.8 17.1 19.9 20 15 10 5 0 1972 1977 1982 1987 22.6 27.2 31.7

(%) 35 30 17.8 20.0 22.0 18.2 23.8 20.5 11.3 9.3 11.8 14.0 25 23.5 19.8 19.2 18.3 21.3 20 15 10 6.1 4.0 3.0 1.5 1.2 0.4 0.1 5 0 1972 1977 1982 1987 19.5 19.8 17.6 16.1 27.7 23.5 21.4 18.5 17.6 7.9 1992 4.7 2.9 1.9 1.4 0.8 0.1 1997 0.02 25 27 29 11 13 15 17 19 21 23

18.0 13.4 10.9 10.4

16.0

16.5 16.4 16.6

1992

1997

Source: Morgan Stanley

Source: Morgan Stanley

Chart 10: Average Timing of Defaults Loan Count

Chart 11: Average Timing of Defaults Loan Amount

1.64 1.71 1.67 1.81 1.66

(%) 2.0 1.8 1.6 1.4 1.2 1.19

(%) 3.0 2.5 2.0 1.08 0.96 1.5 0.72 0.69 0.55 0.51 0.43 0.31 0.43 0.37 0.18 0.14 0.20 0.12 0.04 0.01 0.02 1.0 0.92 0.19 0.5 0.03 0.0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 1 3 5 7 0.91 0.61 0.87 0.43 0.30 0.36 0.24 0.23 0.28 0.15 0.14 0.09 0.08 0.05 0.02 0.04 9 2.68 1.51 1.72 1.84 2.00

0.8 0.6 0.4 0.2 0.0 0.33

Source: Morgan Stanley

Source: Morgan Stanley

24 CMBS WORLD

1.49

1.0

Commercial Mortgage Defaults: 30 Years of History (cont.)

CONCLUSIONS
Chart 12: Liquidated, Restructured and Recovered Loans

3000 2500 2000 1500 1000 500 0 Defaulted 2745 Loans Recovered Loans Returned to Current Status 546 Loans 3.7% Delinquent 102 Loans 19.9% Recovered 546 Loans 24.7% Restructured 679 Loans 61.2% Restructured 334 Loans 51.7% Liquidated 1418 Loans 30.2% Defaulted Again 165 Loans

The results from our update of commercial mortgage defaults through the year 2002 do not significantly change the previous findings on cumulative default and loss rates, the severity of losses on liquidated loans, or the shape of the loss curve.

8.6% Current Again 47 Loans

Howard Esaki is Executive Director, CMBS Research, and Masumi Goldman is Associate, at Morgan Stanley.

See Appendices, p.26-29.

1

Source: Morgan Stanley

Snyderman, Mark P. Commercial Mortgages: Default Occurrence and Estimated Yield Impact. Journal of Portfolio Management, Fall 1991; and Snyderman, Mark P. Update on Commercial Mortgage Defaults. Real Estate Finance, Summer 1994. Esaki, Howard, Steven LHeureux, and Mark P. Snyderman. Commercial Mortgage Defaults: An Update. Real Estate Finance, Spring 1999. Esaki, Howard. Commercial Mortgage Defaults: 1972-2000. Real Estate Finance, Winter 2002. Lans, Diane M. and Noel Cain. Dissecting Defaults and Losses: 2001 CMBS Conduit Loan Default Study. Fitch IBCA Special Report, August 2001.

Our loss estimates are based on a number of assumptions. The most important assumption for loss calculation is that the severity of restructured loans is half that for liquidated loans. If we assume, as some market participants believe, that restructured loans have close to 0% severity, the loss for the worst cohort drops to 6.1%. On the other hand, if we assume that restructured and liquidated loans have the same severity of 33%, the loss rate estimate rises to 10.6%.

would like to thank these 2005 CMBS 101 sponsors!

Their support enables CMSA s continued commitment to education .

CMSA

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Commercial Mortgage Defaults: 30 Years of History (cont.)

Appendix 1

Timing of Defaults by Cohort Loan Count 0 0.33 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 0.00 0.14 0.71 2.33 0.21 0.00 0.28 0.27 0.24 0.75 1.38 1.25 0.00 0.08 0.00 0.21 0.10 0.35 0.41 0.72 0.94 0.21 0.43 0.00 0.00 0.00 1 1.19 2.44 2.99 6.23 2.33 0.82 0.85 0.19 0.36 0.47 0.00 0.92 0.31 1.41 2.40 1.18 0.31 0.29 0.93 3.13 1.20 0.31 0.62 0.00 0.36 0.16 0.00 2 1.64 3.75 5.03 3.26 1.94 0.41 0.14 0.09 0.09 0.24 1.00 2.29 1.10 3.17 2.08 2.16 1.77 1.87 3.13 4.63 1.68 1.88 0.00 0.64 0.36 0.00 0.00 3 1.71 3.56 3.40 1.42 0.58 1.23 0.28 0.00 0.62 0.00 0.50 2.75 4.39 1.94 2.48 2.06 2.71 4.72 3.36 2.18 1.68 1.25 1.04 0.43 0.00 0.00 0.00 4 1.67 3.19 1.49 0.57 0.58 0.21 0.14 0.38 0.18 0.59 0.75 5.05 2.51 4.59 2.56 3.44 4.38 4.13 2.55 2.18 1.20 0.00 0.00 0.21 0.00 0.16 0.00 5 1.81 1.31 0.41 0.71 0.58 0.00 0.28 0.00 0.36 1.30 2.74 1.83 3.29 2.29 3.60 4.92 5.63 4.52 2.09 3.00 0.24 0.00 0.62 0.00 0.00 0.32 0.14 6 1.66 0.19 0.00 0.14 0.39 0.21 0.14 0.09 0.18 2.25 2.00 0.00 0.78 3.70 3.28 8.46 3.65 2.75 2.67 1.09 0.48 0.00 0.21 0.00 0.00 0.16 7 1.08 0.38 0.14 0.14 0.00 0.00 0.71 0.66 2.13 1.54 2.49 1.38 0.47 1.76 1.68 2.26 2.09 1.28 1.74 0.27 0.48 0.00 0.00 0.21 0.71 8 0.96 0.00 0.14 0.14 0.39 0.00 0.56 1.80 0.98 2.01 2.49 3.67 1.88 2.29 1.12 1.28 1.04 1.28 0.70 0.00 0.00 0.00 0.00 0.00 9 0.72 0.00 0.14 0.42 0.39 1.03 1.55 1.14 1.96 1.54 1.25 0.00 0.78 1.59 0.32 0.49 0.31 0.29 0.58 0.27 0.00 0.31 0.21 10 0.69 0.00 0.14 0.00 0.00 0.62 0.99 1.52 1.16 2.01 1.75 0.92 1.10 0.53 0.48 1.08 0.73 0.10 0.23 0.14 0.24 0.00 11 0.55 0.19 0.00 0.14 1.17 1.23 0.56 0.85 1.16 2.01 2.24 0.92 0.16 0.35 0.08 0.20 0.42 0.00 0.12 0.27 0.00 12 0.51 0.19 0.82 0.42 1.36 0.41 0.14 1.42 1.51 1.42 0.75 0.00 0.16 0.00 0.16 0.10 0.21 0.00 0.12 0.00 13 0.43 0.38 0.95 0.71 0.58 0.21 0.56 0.66 1.42 0.83 0.25 0.46 0.00 0.18 0.08 0.10 0.00 0.10 0.00 14 0.31 0.75 0.68 0.42 0.78 0.21 0.42 0.95 0.80 0.12 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 15 0.43 0.94 0.82 0.71 0.78 1.85 0.56 0.95 0.36 0.24 0.50 0.00 0.00 0.00 0.00 0.00 0.00

Sources: Life insurance company annual statements; Morgan Stanley

26 CMBS WORLD

Commercial Mortgage Defaults: 30 Years of History (cont.)

16 0.37 0.56 0.68 0.71 0.78 0.82 0.85 0.57 0.18 0.36 0.25 0.00 0.00 0.00 0.08 0.00

17 0.18 0.19 0.14 0.28 0.58 0.41 0.00 0.09 0.36 0.24 0.25 0.46 0.00 0.00 0.00

18 0.14 0.19 0.27 0.28 0.39 0.62 0.28 0.00 0.00 0.00 0.00 0.00 0.00 0.00

19 0.20 0.75 0.82 0.14 0.00 0.62 0.14 0.00 0.00 0.12 0.00 0.00 0.00

20 0.12 0.38 0.27 0.00 0.00 0.21 0.00 0.19 0.00 0.24 0.00 0.00

21 0.04 0.00 0.27 0.00 0.00 0.00 0.14 0.00 0.00 0.00 0.00

22 0.01 0.19 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

23 0.02 0.00 0.14 0.00 0.00 0.00 0.00 0.00 0.00

24 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

25 0.03 0.00 0.00 0.00 0.19 0.00 0.00

26 0.00 0.00 0.00 0.00 0.00 0.00

27 0.00 0.00 0.00 0.00 0.00

28 0.00 0.00 0.00 0.00

29 0.00 0.00 0.00

30 0.00 0.00

10-Year Lifetime % in 10 Total Total Years 13.02 14.82 13.99 13.74 9.51 4.72 5.65 6.16 8.27 12.20 15.71 20.18 17.87 23.28 20.10 27.34 22.84 21.34 18.31 17.30 7.93 4.69 2.90 1.93 1.42 0.80 0.14 15.27 19.51 19.84 17.56 16.12 11.29 9.32 11.85 14.04 17.77 19.95 22.02 18.18 23.81 20.50 27.73 23.46 21.44 18.54 17.57 7.93 4.69 2.90 1.93 1.42 0.80 0.14 85.25 75.96 70.55 78.23 59.04 41.82 60.61 52.00 58.86 68.67 78.75 91.67 98.28 97.78 98.05 98.58 97.33 99.54 98.75 98.45 100.00 100.00 100.00 100.00 100.00 100.00 100.00

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Commercial Mortgage Defaults: 30 Years of History (cont.)

Appendix 2

Timing of Defaults by Cohort Loan Size

0 0.19 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 0.00 0.26 0.81 1.91 0.32 0.00 0.14 0.11 0.08 0.69 0.73 0.82 0.00 0.05 0.00 0.13 0.09 0.10 0.09 0.50 1.05 0.27 0.34 0.00 0.00 0.00

1 0.92 1.68 2.24 7.10 3.04 1.35 1.44 0.07 0.32 0.25 0.00 1.54 0.16 1.27 2.33 0.92 0.20 0.28 1.28 2.47 1.22 0.18 0.37 0.00 0.09 0.10 0.00

2 1.51 2.52 4.59 4.55 1.18 0.15 0.04 0.04 0.97 0.16 0.57 1.77 1.09 1.99 1.83 2.28 1.23 1.85 2.38 5.95 0.85 1.39 0.00 0.69 0.34 0.00 0.00

3 1.72 2.99 2.46 1.02 0.54 1.69 2.76 0.00 0.57 0.00 0.50 1.44 3.81 1.22 2.45 2.14 2.86 3.65 3.55 1.80 1.11 0.80 1.81 0.17 0.00 0.00 0.00

4 1.84 10.20 1.06 0.74 0.20 0.15 0.04 0.29 0.43 0.53 0.53 2.66 2.46 2.52 2.92 3.25 4.60 3.47 1.85 2.87 1.27 0.00 0.00 0.23 0.00 0.08 0.00

5 2.00 1.25 0.40 0.85 0.23 0.00 2.83 0.00 0.28 2.16 2.21 1.31 2.99 1.14 2.90 5.82 4.73 3.43 1.84 3.26 0.37 0.00 0.37 0.00 0.00 0.14 0.11

6 2.68 0.06 0.00 0.07 0.15 0.07 0.18 0.03 0.14 1.69 0.83 0.00 1.53 7.76 2.86 10.30 4.63 4.25 4.33 1.02 0.37 0.00 0.10 0.00 0.00 0.13

7 1.49 0.23 0.05 0.12 0.00 0.00 3.33 0.47 2.62 1.22 2.05 0.53 0.80 4.79 2.24 2.47 2.84 1.42 1.50 0.27 0.18 0.00 0.00 0.03 0.78

8 0.91 0.00 0.15 0.11 0.44 0.00 0.40 1.48 0.98 1.22 3.44 3.19 1.84 2.75 1.30 1.31 0.49 1.16 0.49 0.00 0.00 0.00 0.00 0.00

9 0.61 0.00 0.04 0.96 0.67 0.88 1.76 1.64 2.27 1.53 0.92 0.00 0.65 2.27 0.38 0.24 0.18 0.13 0.56 0.10 0.00 0.57 0.11

10 0.87 0.00 0.11 0.00 0.00 0.73 0.44 1.63 0.89 2.05 2.11 4.42 0.79 0.17 0.93 2.32 1.07 0.08 0.73 0.03 0.28 0.00

11 0.43 0.22 0.00 0.07 1.11 0.72 0.53 0.80 0.90 1.54 0.91 0.68 0.14 1.18 0.07 0.23 0.41 0.00 0.49 0.46 0.00

12 0.30 0.08 0.42 0.41 1.58 0.58 0.03 1.13 1.32 0.92 0.48 0.00 0.04 0.00 0.27 0.31 0.10 0.00 0.15 0.00

13 0.36 0.23 0.80 0.42 0.19 0.10 0.33 0.46 3.13 1.27 0.04 2.39 0.00 0.10 0.32 0.06 0.00 0.03 0.00

14 0.24 0.69 0.50 0.38 0.59 0.07 2.22 0.83 0.42 0.80 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

15 0.23 0.54 0.72 0.60 0.25 1.79 1.00 0.61 0.18 0.25 0.43 0.00 0.00 0.00 0.00 0.00 0.00

Sources: Life insurance company annual statements; Morgan Stanley

28 CMBS WORLD

Commercial Mortgage Defaults: 30 Years of History (cont.)

16 0.28 0.70 0.49 0.52 0.39 0.39 0.46 0.49 0.38 0.50 0.15 0.00 0.00 0.00 0.46 0.00

17 0.15 0.14 0.05 0.15 0.41 0.35 0.00 0.14 0.55 0.11 0.73 0.15 0.00 0.00 0.00

18 0.14 0.10 0.12 0.74 0.36 1.10 0.09 0.00 0.00 0.00 0.00 0.00 0.00 0.00

19 0.09 0.47 0.36 0.27 0.00 0.35 0.04 0.00 0.00 0.03 0.00 0.00 0.00

20 0.08 0.16 0.40 0.00 0.00 0.11 0.00 0.16 0.00 0.08 0.00 0.00

21 0.05 0.00 0.44 0.00 0.00 0.00 0.08 0.00 0.00 0.00 0.00

22 0.02 0.35 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

23 0.04 0.00 0.38 0.00 0.00 0.00 0.00 0.00 0.00

24 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

25 0.02 0.00 0.00 0.00 0.11 0.00 0.00

26 0.00 0.00 0.00 0.00 0.00 0.00

27 0.00 0.00 0.00 0.00 0.00

28 0.00 0.00 0.00 0.00

29 0.00 0.00 0.00

30 0.00 0.00

10-Year Lifetime % in 10 Total Total Years 13.89 18.94 11.35 16.33 8.36 5.34 13.21 5.78 9.59 10.89 13.84 17.59 16.95 25.88 20.17 31.05 22.95 19.81 18.60 17.85 6.14 4.00 3.03 1.47 1.20 0.44 0.11 12.48 15.20 22.63 16.03 19.90 13.36 10.90 18.00 10.40 16.47 16.38 16.58 20.80 17.13 27.16 21.29 31.66 23.46 19.83 19.24 18.31 6.14 4.00 3.03 1.47 1.20 0.44 0.11 14.58 85.81 83.71 70.83 82.08 62.55 48.98 73.41 55.64 58.21 66.50 83.48 84.53 98.92 95.28 94.75 98.09 97.82 99.87 96.70 97.49 100.00 100.00 100.00 100.00 100.00 100.00 100.00 85.60

WINTER 2005

29

30 CMBS WORLD

Rising Interest Rates Impact on Floating Rate CMBS

Frank Innaurato, Stephen Kuritz, Kevin Hendrickson, and Robert Grenda
Investors and consumers alike have enjoyed the benefits of historically low interest rates during the past few years. Unfortunately, an improving economy and concerns about escalating inflation have prompted the Federal Reserve to raise the federal funds rate by 75 basis points (bp) between January and September 2004. LIBOR rates have followed the Feds actions by rising as well. Between midSeptember 2003 and mid-September 2004, the one-month LIBOR rate has increased by 67 bp from 1.12% to 1.79%. While no one can accurately predict the direction and timing of interest rates changes, there is a strong chance that interest rates will move higher in the next few years. The theme of this paper is to look at the effects of rising interest rates on floating rate commercial mortgage-backed securities (CMBS) transactions. How do debt service coverage ratios (DSCRs) on floating rate loans hold up when stressed at higher interest rate levels? How many loans might be at risk of default under various scenarios? How will credit ratings and support levels hold up under these stressed scenarios? We address these questions in this article.

A trend of more downgrades could persist as vacancy rates in many

Innaurato

widen sharply if a major market event like the bond market crisis of 1998 were to occur again. The threat of rising interest rates, a combination of LIBOR rates and commercial mortgage spreads, pose a major risk for borrowers, lenders and bond investors. While many floating rate CMBS transactions have historically contained loans with high initial DSCRs, we have seen several deals suffer downgrades in recent years due to sharp declines in property cash flows. Between June 2003 and August 2004, there were 93 tranches downgraded in CMBS floaters with some classes being downgraded more than once. The vast majority of the downgrades resulted not from diminished subordination levels but because the underlying loans suffered substantial declines in net cash flow. The potential threat of loan defaults has motivated the rating agencies to take action.

Kuritz

THE FLOATING RATE LOAN UNIVERSE

In mid-September 2004, the Realpoint CMBS database contained nearly 50,000 loans with a combined outstanding balance of roughly $387 billion. While Floating Rate Loan (FRL) exposure is small at slightly more than 8%, FRLs constitute a large portion of the securitized loans due to mature between September 2004 and September 2005. During this 12-month period, 885 fixed- and floating rate loans with a total balance of $15 billion are scheduled to mature of which 345 loans with a balance of $10 billion are FRLs. Moreover, through September 2006, 605 FRLs with a $22.6 billion balance will come due. Mortgage rates for FRLs vary considerably, from less than 2% to greater than 10%, with the greatest proportion of loans having rates between 2% and 7% (88%). Of the 1,339 FRLs, 390 loans with a combined balance of $18.4 billion (58%) have mortgage rates below 4%.

Hendrickson

Grenda

COMPETITIVE PRESSURES
While all eyes should remain focused on the trend in inflation and the Feds pronouncements, it is also important to watch for changes in market conditions and spreads on commercial mortgage loans. Intense competition among lenders has caused spreads to fall significantly over the last several years. Presently, commercial mortgage spreads remain extremely low relative to historic levels. Spreads on floating rate loans have risen slightly during the past nine months, but could

SAMPLE POOL

OF

FLOATING RATE LOANS

We selected 565 securitized FRLs with a combined

WINTER 2005 31

Rising Interest Rates Impact on Floating Rate CMBS

(cont.)

Chart 1: Floating Rate Loan Maturity

Maturity (months) 0 to 12 13 to 24 25 to 36 37 to 48 49 to 60 61 to 72 > 72 Total

Source: Realpoint

Floating Rate # of Loans 345 264 152 102 70 34 372 1339

Unpaid Balance $ bill. $10.11 $12.47 $2.76 $0.67 $0.70 $0.70 $4.57 $31.97

% of Unpaid Balance 31.6% 39.0% 8.6% 2.1% 2.2% 2.2% 14.3% 100.0%

2003 operating results were not available, we relied on annualized 2004 operating results if they included at least six months of operations. No 3-month operating statements were used. Rising interest rates in theory should affect all securitized FRLs, since higher rates will invariably lead to higher debt service payments and lower DSCRs. Needless to say, higher rates should have their greatest impact in terms of the probability of default on those FRLs which are already underperforming as measured by the DSCR. For the purposes of this paper, we used a DSCR of 1.20 or lower as the high risk threshold. That is, those loans with a DSCR below 1.20 were categorized as high risk loans. Of the 565 loans in our sample, just 56 loans with a combined $841 million balance (5.4% of unpaid balance for our sample) had pre-test debt service coverage of 1.20 or below. This includes 41 loans, 4.2% of unpaid balance for our sample, with coverage of 1.00 or lower. As of September 2004, the vast majority of FRLs with available operating results had DSCRs greater than 1.20 (94.6% of unpaid balance for our sample), while just 12% of FRLs have coverage of 2.00 or below. In the world of securitized fixed-rate loans, assuming no recent volatility, debt service coverage of 1.20 is generally adequate if the debt service includes interest and principal. Thus, the majority of FRLs have DSCRs that suggest stable performance. However, because many FRLs are interest only loans, 1.20 debt service coverage usually indicates a loan with increased risk. It remains to be seen, however, how these FRLs would respond to future cash flow shocks due to higher interest rates and margins.

Chart 2: Coupon Rates for Floating Rate Loans

Floating Rate # of Loans 12 694 280 318 35 1339 Unpaid Balance $ bill. $1.92 $22.20 $5.85 $1.69 $0.31 $31.97 % of Unpaid Balance 6.0% 69.4% 18.3% 5.3% 1.0% 100.0%

Coupon Less than 2.001 2.001 to 5.000 5.001 to 7.000 7.001 to 10.000 > 10.001 Total
Source: Realpoint

Chart 3: DSCR Distribution for Floating Rate Loans

% of Total FRL Unpaid Balance 0.5% 0.8% 0.1% 0.3% 0.1% 0.2% 0.1% 1.8% 28.9% 32.8% % of Unpaid Balance - DSCR Sample 1.6% 2.6% 0.2% 1.0% 0.2% 0.5% 0.3% 5.3% 88.2% 100.0%

DSCR < 0.50 0.50+ to 1.0 1.0+ to 1.10 1.10+ to 1.20 1.20+ to 1.30 1.30+ to 1.40 1.40+ to 1.50 1.50+ to 2.0 2.0+ DSCR Sample
Source: Realpoint

Floating Rate # of Loans 18 23 4 11 3 6 4 44 452 565

Unpaid Balance $ bill. $255.0 $401.4 $31.4 $153.5 $37.3 $82.0 $39.3 $834.6 $13,772.0 $15,606.4

INTEREST RATE STRESS TEST

Our stress test involved raising interest rates in 100 basis point increments for the 565 loans in our sample. We measured the results of each rate increase to determine the level of decline in individual loan DSCRs and each loans breakeven threshold. The results of our interest rate stress test are shown in Charts 4 and 5. As one might expect, the number and percentage of high risk loans (1.20 or below) increases with each incremental interest rate increase.
Rates Rise by 100 Basis Points Some Credit Deterioration

balance of $15.6 billion for our stress test. These loans were chosen because we were able to collect adequate operating statement information for the underlying properties. To ensure that the loans operating results accurately reflect the performance of the underlying collateral, we included only those loans securitized before 2004 which had recently reported operating results for a period of at least two consecutive quarters. In most cases, we used the operating results for the 12month period ended December 31, 2003. If year-end
32 CMBS WORLD

The number of loans with DSCRs of 1.20 and below rises to 65 from 56 with an increase of $119 million in balances below 1.2. Below 1.0 loans jump from 41 to 52 as an additional $108.4 million of loans now drop below breakeven. An additional 21 loans with balances of $686.9

Rising Interest Rates Impact on Floating Rate CMBS

(cont.)

Chart 4: DSCR Comparison 100, 200 and 300 Basis Point Increases

Current DSCR DSCRs 1.10+ to 1.20 1.0+ to 1.10 0.50+ to 1.0 < 0.50 >2.0 1.50+ to 2.0 1.40+ to 1.50 1.30+ to 1.40 1.20+ to 1.30 Loans 11 4 23 18 56 452 44 4 6 3 509
Source: Realpoint

DSCR @ +100 bp increase % of UPB 1.0% 0.2% 2.6% 1.6% 5.4% 88.2% 5.3% 0.3% 0.5% 0.2% 94.6% Loans 5 8 31 21 65 421 45 14 10 10 500 UPB $79.2 $116.7 $485.3 $279.5 $960.7 $12,858.6 $938.6 $585.9 $100.3 $162.3 $14,645.7 % of UPB 0.5% 0.7% 3.1% 1.8% 6.2% 82.4% 6.0% 3.8% 0.6% 1.0% 93.8% 9 13 40 22 84 380 64 13 10 14 481

DSCR @ +200 bp increase Loans UPB $135.2 $382.0 $647.0 $283.5 $1,447.7 $11,681.8 $1,736.2 $243.0 $140.9 $356.6 $14,158.5 % of UPB 0.9% 2.4% 4.1% 1.8% 9.3% 74.9% 11.1% 1.6% 0.9% 2.3% 90.7%

DSCR @ +300 bp increase Loans 12 13 52 27 104 336 83 14 12 16 461 UPB $144.6 $359.6 $1,050.7 $360.1 $1,915.0 $10,188.9 $2,657.9 $357.1 $340.4 $147.0 $13,691.3 % of UPB 0.9% 2.3% 6.7% 2.3% 12.3% 65.3% 17.0% 2.3% 2.2% 0.9% 87.7%

UPB $153.5 $31.4 $401.4 $255.0 $841.3 $13,772.0 $834.6 $39.3 $82.0 $37.3 $14,765.2

Chart 5: DSCR Comparison 400 and 500 Basis Point Increases

Current DSCR Loans 1.10+ to 1.20 1.0+ to 1.10 0.50+ to 1.0 < 0.50 >2.0 1.50+ to 2.0 1.40+ to 1.50 1.30+ to 1.40 1.20+ to 1.30 11 4 23 18 56 452 44 4 6 3 509
Source: Realpoint

DSCR @ +400 bp increase % of UPB 1.0% 0.2% 2.6% 1.6% 5.4% 88.2% 5.3% 0.3% 0.5% 0.2% 94.6% Loans 14 18 60 31 123 284 97 24 22 15 442 UPB $185.9 $177.3 $1,256.8 $506.2 $2,126.2 $6,514.7 $5,095.4 $803.6 $527.2 $539.4 $13,480.3 % of UPB 1.2% 1.1% 8.1% 3.2% 13.6% 41.7% 32.6% 5.1% 3.4% 3.5% 86.4% Loans 23 14 75 35 147 209 137 20 27 25 418

DSCR @ +500 bp increase UPB $738.9 $170.2 $1,384.2 $582.1 $2,875.4 $3,798.2 $6,408.1 $1,000.2 $626.1 $898.4 $12,731.0 % of UPB 4.7% 1.1% 8.9% 3.7% 18.4% 24.3% 41.1% 6.4% 4.0% 5.8% 81.6%

UPB $153.5 $31.4 $401.4 $255.0 $841.3 $13,772.0 $834.6 $39.3 $82.0 $37.3 $14,765.2

million fall in the 1.2 to 1.5 DSCR category. Only one loan drops into the 1.5 to 2.0 DSCR category.
Rates Rise by 200 Basis PointsFeeling Some Pain

Rates Rise by 300 Basis PointsRising Defaults

9.0% of UPB with below 1.0 DSCR. 127.6% increase in UPB for loans with a DSCR below 1.20 and a 12.0% decline in UPB for loans with a DSCR above 1.50. 104 loans considered high risk up from 56 in the base case. 12% of FRLs will fall into the high risk category (DSCR of 1.20 or lower).
Rates Rise by 400 Basis PointsSignificant Pain

A 72.1% increase in unpaid principal balance (UPB) for loans with a DSCR below 1.20 and a 8.1% decline in UPB for loans with a DSCR above 1.50. High risk loans jump to 9.3% of UPB, including 62 (6% UPB) with DSCRs of 1.00 or below. Significant portion of near 1.5 DSCR loans fall closer to 1.2 DSCR. UPB of loans with DSCRs of 1.5 to 2.0 nearly doubles as 20 assets experience reduced coverage. 72 loans ($2.09 billion) drop below 2.0 DSCR.

152.7% increase in UPB for loans with a DSCR below 1.20 and a 20.5% decline in UPB for loans with a DSCR above 1.50. 91 loans with below 1.0 DSCR.

WINTER 2005

33

Rising Interest Rates Impact on Floating Rate CMBS

(cont.)

Chart 6: DSCR Stratification High Risk Loans (DSCRs Less Than 1.20)

3000 2500 Unpaid Balance 2000 1500 283.5 1000 279.5 500 0 < 0.50 0.50+ to 1.0 1.0+ to 1.10 1.10+ to 1.20 485.3 116.7 79.2 100 279.5 485.3 116.7 79.2 647 382.01 135.2 200 283.5 647 382.01 135.2 359.6 144.6 300 360.1 1050.7 359.6 144.6 Basis Point Increase 177.3 185.9 400 506.2 1256.8 177.3 185.9 1050.7 360.1 506.2 1384.2 582.1

1256.8 170.2 738.9 500 582.1 1384.2 170.2 738.9

Source: Realpoint

Chart 7: Change in Weighted Average DSCR at Each Basis Point Increase

Basis Point Increase Current Data +100 bp +200 bp +300 bp +400 bp +500 bp
Source: Realpoint

Chart 8: Weighted Average DSCR Sample Study

Weighted Average DSCR 4.59 3.34 2.65 2.21 1.90 1.66

% Change in DSCR N/A -27.1% -42.2%

DSCR

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

4.59

3.34 2.65 2.21 1.90 1.66

-51.9% -58.7% -63.8%

Rates Rise by 500 Basis PointsDoomsday Scenario

Current Data

+100 bp

+200 bp

+300 bp

+400 bp

+500 bp

Basis Point Inrease

110 loans, 12.6% of UPB, failing to meet debt service. 241.8% increase in UPB for loans with a DSCR below 1.20 and a 30.1% decline in UPB for loans with a DSCR above 1.50. We also segregated the higher balance loans ($10 million and above) to see how they would respond, as measured by the DSCRs, to higher rates. Again, our high risk threshold was below a 1.20 DSCR. Our initial sample included 27 high risk loans with a balance of $10 million or greater ($689.4 million combined, 4.4% of sample), including seven loans with balances of $30 million or greater. The number and balance edged up slightly at the 100 bp stress level, rising to 32 loans totaling $782.8 million, 5.0% of the sample. The $30+ million loans showed no change. Increasing the interest rate another 100 bp raised the number of high risk $10+ million loans to 40 with a UPB of $1.22 billion, 7.8%. At the 300 bp stress
34 CMBS WORLD

Source: Realpoint

level, 49 loans totaling $1.63 billion (10.4%) fell into the high risk category. What is noteworthy is that at the 300 bp stress level, 15 loans of $30 million or greater ($979 million) slide into the high risk zone, including six loans at $50 million or greater ($639 million). The increase of 100 bp is acceptable relative to the change in coverage. Concerns mount at the 200 bp level as more than 42% of weighted average debt service coverage is lost. An increase to 300 bp drops weighted average DSCR by 52% from the original level, signifying a large loss of pool coverage. The worst-case scenarios of 400 bp and 500 bp cause

Rising Interest Rates Impact on Floating Rate CMBS

(cont.)

coverage to drop well below current levels, and will cause a significant increase in default risk and trigger several ratings downgrades.

availability of extension options helps to mitigate the impact of rising rates and provides additional time to find refinancing alternatives. In CMBS floaters, a variety of structural features serve to lessen credit risk. These include markedly higher credit support levels compared with conduit deals, higher balance first loss tranches, higher initial DSCRs, split loans (with only partial securitization of the debt) that result in lower loan to value ratios (LTVs), maturity extension options and interest rate caps. All of these features help to mitigate risk at both the loan/asset and certificate levels, even as interest rates move higher. Finally, we have reached a point in the real estate cycle when investors should be more aggressive in their refinancing efforts to go long and lock in fixed interest rates. For the better part of 2004, we have seen short-term interest rates rise sharply while long-term rates have remained fairly unchanged. We believe the performance of the property and credit markets has more of an immediate impact on the performance of floating rate deals. The inability to cover debt service because of a drop in cash flow remains the greater risk. Given our outlook for slightly higher interest rates in 2005, we dont expect to experience the stressed levels covered in this study.

CONCLUSION
Over the past few years, the rating agencies have moved aggressively in downgrading CMBS classes secured by FRL pools with declining cash flows. If the recent past is any indication of the future, significantly higher interest rates could cause a large wave of downgrades in floater deals. We would expect to see downgrades begin at the 200 bp level and intensify as you hit the 300 bp and higher levels. Many seasoned floating rate transactions have also experienced large increases in subordination in recent years due to significant prepayments. The levels of subordination reached at the mid and high investmentgrade classes are more than adequate to buffer these seasoned classes from experiencing losses. Only in the severe stressed scenarios of 400 bp and 500 bp rate increases would the investment-grade classes begin to experience some problems. A second likely outcome of higher rates is a higher incidence of loan extensions. To mitigate this risk, many FRLs allow for at least one extension, and borrowers frequently exercise this option. The use of extensions is not necessarily considered a sign of problems. The

Frank Innaurato is Vice President of CMBS Research at

WINTER 2005

35

CDC MORTGAGE CAPITAL

(a name to forget)

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36 CMBS WORLD

Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

Paul Staples and Sally Gordon
The growing prevalence of interest only (IO) loans in recent commercial mortgage-backed securities (CMBS) offerings has caused concern among many investors because they fail to reap any of the benefits of amortization. For 2004 through Gordon June, the average fusion deal had 40.3% of its pool balance consisting of full-term and partial-term IO loans. Of this total, the composition was 36% full-term IOs and 64% partial-term IOs. Even prior to the IO trend, many market participants were concerned about refinancing todays low coupon loans at a future balloon date with potentially higher interest rates. In their minds, this risk is being compounded by less and less amortization in todays loans. This article addresses the impact of the IO structure on term and balloon risk. The analysis employs the use of both simple mathematical examples as well as Moodys Commercial Mortgage Metrics (CMM). Among other things, the paper makes the following points: Higher interest rates at refinance increase balloon risk. Lower coupon loans amortize at a faster rate than do higher coupon loans. Relative to higher coupon loans, lower coupon loans can have additional initial leverage and still have the same balloon amount as well as a higher initial debt service coverage ratio (DSCR). Lower coupon loans can have initial IO periods and still have the same balloon amount as some higher coupon loans. The benefit of faster amortization and higher DSCR provided by low interest rates is typically nullified by additional leverage.

For a fixed-rate loan, the impact of changing interest rates is primarily f e l ta t

CMM will specifically quantify the term risk benefit of higher DSCRs and how this benefit helps to offset otherwise negative loan characteristics such as additional leverage and partial IO periods.

PRELIMINARY DEFINITIONS

AND

ASSUMPTIONS

This study examines the term and balloon risk implications for IO loan structures. Term risk refers to the probability that a loan will default prior to maturity. Balloon risk refers to the probability that a loan will default at maturity due to the inability to refinance. The differentiation is often made because different factors can affect the probability of default during the term versus balloon. For example, prior to maturity a loan will not typically default provided property cash flow is at least equal to or greater than the required debt service payment (i.e., the DSCR is >= 1.0). In contrast, a loan at maturity usually needs to be refinanced. In this case, simply having a recent DSCR >=1.0 may not be sufficient since refinancing parameters at balloon may not imply a loan size as large as the amount needing to be refinanced. For example, at balloon a lender looking to refinance the loan may size a new loan at 1.25 DSCR assuming a 9.25% mortgage coupon. Using these new refinance parameters with the propertys current cash flow may result in a loan amount that is less than that due at maturity (implying default at maturity). It is the introduction of the refinance assumptions (DSCR and mortgage constant) at maturity that makes dividing default risk into term and balloon a valuable exercise. For a fixed-rate loan, the impact of changing interest rates is primarily felt at balloon when its time to refinance. So, we can say that term risk is primarily driven by property cash flow and balloon risk is driven both by property cash flow and the capital markets.
WINTER 2005 37

Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

(cont.)

Chart 1: Effect of Rate on Initial Loan Amount Keeping DSCR Constant

Rate Beginning Loan Amt Balloon Loan Amt Beginning LTV Balloon LTV DSCR % of Base Index

9.25% $898,248 80.0% 71.9% 1.25 100.0%

8.25% $965,262 87.6% 77.2% 1.25 109.5%

7.25% $1,205,683 $1,040,629 96.5% 83.3% 1.25 120.6%

6.25%

5.25%

$1,000,000 $1,094,773

$1,336,051 $1,489,198 $1,125,459 $1,220,373 106.9% 90.0% 1.25 133.6% 119.1% 97.6% 1.25 148.9%

a default occurs. With respect to balloon risk, loans with lower balloon balances are preferred to those with higher balloon balances. In any interest rate environment, a lower balloon balance will be easier to refinance than a higher balloon balance. In this article, the terms interest rate and coupon are used carefully. Coupon refers to the rate paid on an existing mortgage whereas interest rate refers to potential interest rates at maturity. So, a loan with a given coupon will need to be refinanced at the market interest rate (plus some credit risk spread) prevailing at maturity. The interest rate at which such loan is refinanced will then become that new loans coupon.

Note: 1. All loans have amortization schedule of 360 months. Balloon balance is at end of month 120. 2. % of Base Index represents Beginning Loan Amount divided by $1 million.

Chart 2: Refinancing a Low-Coupon Loan in a Rising Interest Rate Environment

Base Case Loan to be Refinanced: Loan Amount Amort (Mos) Rate DSCR Refinance Rate Year 5 Refinance Required Refi DSCR Total Cash Flow Growth Required Per Annum Cash Flow Growth Year 10 Refinance Required Refi DSCR Total Cash Flow Growth Required Per Annum Cash Flow Growth 1.25 -18.1% -2.0% 1.25 -8.6% -0.9% 1.25 1.2% 0.1% 1.25 11.5% 1.1% 1.25 22.1% 2.0% 1.25 -7.9% -1.6% 1.25 2.7% 0.5% 1.25 13.8% 2.6% 1.25 25.4% 4.6% 1.25 37.3% 6.5% 5.25% $1,000,000 360 5.25% 1.25 6.25% Beg. Cash Flow D/S Payment Balloon Amount Yr 5 Balloon Amount Yr 10 7.25% 8.25% $82,831 $66,264 $921,495 $819,483 9.25%

HIGHER REFINANCE INTEREST RATES INCREASE BALLOON RISK AND REQUIRE CASH FLOW GROWTH
This section highlights the importance of changing interest rates and why an analysis of balloon risk is worthwhile. Relatively higher interest rates imply a lower potential loan amount given a constant DSCR. A recent paper by Moodys used CMM to analyze balloon risk in an environment of rising interest rates, among other things. As expected, higher interest rates implied higher default probabilities. The paper also examined the sensitivity of balloon risk to other factors. The impact of interest rates on refinance loan size can be illustrated by a simple example. Chart 1 shows the implied mortgage for the same cash flow at various coupon rates while holding DSCR constant at 1.25. Also shown is the percentage that each loan represents as compared to the low coupon loan. For example, the first column shows that given a coupon rate of 5.25% and a 1.25X DSCR, property cash flow can support a $1.0 million loan. The second column shows that the same property cash flow can only support a smaller loan balance of $896,860 if the coupon is 6.25%. The last row in the second column indicates that this lower loan balance represents 89.7% of the $1 million base case loan. This implies that for a 100 basis point change in the coupon (from 5.25% to 6.25%), the loan proceeds decline by 10% (from $1 million to $896,860). Clearly, in order for lower coupon loans to be refinanced in higher interest rate environments, it is necessary for property cash flow to improve so that the same 1.25 DSCR will justify or support a larger initial loan amount. This is the characteristic that market participants are often referring to when speaking about balloon risk and higher interest rates. If interest rates rise and property cash flow hasnt grown enough to offset the increase in rates, the size of the refinance loan may not be sufficient to pay off the balance of the existing loan. Chart 2 shows how much cash flow needs to grow (on a total and per annum basis) in order to refinance a 5.25% coupon loan in Years 5 and 10 at the respective refinance coupons.

Chart 3: Lower Coupon Loans Amortize Faster

$1,100,000

$1,000,000
Loan Balance

$900,000

$800,000 5.25% Coupon Balance $700,000 0 1 2 3 4 5 Year Ending 6 7 8 9 10 9.25% Coupon Balance

While term and balloon risk are affected by many factors, some simplifying assumptions need to be made in this paper. With respect to term risk, it is assumed that loans with relatively higher DSCRs have better term risk than loans with lower DSCRs. The higher DSCR provides a bigger cushion to absorb property cash flow decline before
38 CMBS WORLD

Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

(cont.)

Chart 4: Effect of Rate on Initial Loan Amount Keeping Balloon Amount Constant
Rate Beginning Loan Amt Balloon Loan Amt Beginning LTV Balloon LTV DSCR % of Base Index 9.25% $898,248 80.0% 71.9% 1.25 100.0% 8.25% $898,248 81.5% 71.9% 1.34 101.9% 7.25% $1,040,719 $898,248 83.3% 71.9% 1.45 104.1% 6.25% $898,248 85.3% 71.9% 1.57 106.6% 5.25% $898,248 87.7% 71.9% 1.70 109.6%

$1,000,000 $1,018,768

$1,066,325 $1,096,116

Note: 1. All loans have amortization schedule of 360 months. Balloon balance is at end of month 120. 2. % of Base Index represents Beginning Loan Amount divided by $1 million.

loans, it is important to underscore the fact that lower coupon rates result in faster amortization. Chart 3 compares two loans with the same beginning balance, one with a 9.25% coupon and the other with a 5.25% coupon. By the end of Year 10, the lower coupon loan has amortized an additional 8.8% as compared to the higher coupon loan. All else being equal, a lower balloon amount implies lower refinance risk. Additionally, the lower coupon loan will also have a higher DSCR due to its lower debt service payments. So, for the same initial loan amount, the lower coupon loan has relatively better term and balloon risk as compared to the higher coupon loan (since it has a higher DSCR and lower average loan balance over the term).

Chart 5: More Leverage but Same Balloon

LOWER COUPONS MAY ALLOW ADDITIONAL LEVERAGE WITHOUT INCREASING TOTAL RISK
If the lower coupon loan has better term and balloon risk than the high coupon loan (given the same initial loan amount), then it would seem possible to increase loan proceeds on the lower coupon loan so that the risk profile is similar to that of the high coupon loan. Chart 4 details the varying interest rates and respective initial loan proceeds that result in the same balloon amounts. Note that in addition to having identical balloon amounts, the lower coupon loans can have significantly better initial DSCRs as compared to the higher coupon loans. Are the lower coupon loans in Chart 4 better credit risks than the higher coupon loans when considering the additional leverage? For example, is the $1.1 million loan at a 5.25% coupon a better credit risk than the $1.0 million loan at 9.25%? They have the same balloon risk (because of identical balloon balances), but the $1.1 million loan has lower implied term risk due to a higher DSCR. However, it takes ten years for the LTVs to converge to the same level at maturity, so the more leveraged loan has a higher average LTV (loan to value ratio) prior to balloon. The higher leveraged loans could be better credit risks than the lower balance loans if the increase in DSCR (due to lower coupon) is enough to offset the higher average LTV. Chart 5 is similar to Chart 3, but now the higher leveraged loan is added. The gap between the 9.25% Coupon Balance and the 5.25% CouponMore Leverage series is the additional LTV over the term as compared to the benchmark loan. Note that the $1.1 million 5.25% coupon loan ends with the same balloon balance as the benchmark $1.0 million 9.25% coupon loan. In deciding which loan in Chart 5 is the better credit risk, the key piece of information is how much the probability of default varies with DSCR. If significant weight is given to the improved DSCR then still more leverage could be added (even higher balloon amount) and the overall risk profile (term plus balloon) might be equal to that of the 9.25% coupon loan. Intuitively, it seems that when choosing between two loans with the same balloon balance, the one
WINTER 2005 39

$1,100,000

$1,000,000
Loan Balance

$900,000

$800,000 5.25% Coupon Balance $700,000 0 1 2 3 4 5 Year Ending 6 7 8 9 10 9.25% Coupon Balance 5.25% CouponMore Leverage

Chart 6: Effect of Rate on Breakeven Initial IO Period Keeping Balloon Balance Constant
Rate Months of Initial IO Period Beginning Loan Amt Balloon Loan Amt Beginning LTV Balloon LTV 9.25% 0 $898,248 80.0% 71.9% 8.25% 11 $897,022 80.0% 71.8% 7.25% 23 $1,000,000 $897,518 80.0% 71.8% 6.25% 34 $1,000,000 $897,392 80.0% 71.8% 5.25% 44 $1,000,000 $896,848 80.0% 71.7%

$1,000,000 $1,000,000

Note: 1. All loans have amortization schedule of 360 months after initial IO period. Balloon balance is at end of month 120. 2. % of Base Index represents Beginning Loan Amount divided by $1 million.

Chart 2 illustrates several interesting things. First, the negative cash flow growth for three of the scenarios (5-year 5.25% and 10-year 5.25% and 6.25%) means that cash flow can actually decline and the loan can still be refinanced. This is simply the result of amortization reducing the outstanding loan balance enough to allow this. The second obvious but important observation is that over a five year time frame, cash flow needs to grow faster (or can decline less) than over a ten year time frame on both a total and per annum basis.

LOWER COUPONS PROVIDE FASTER AMORTIZATION

Before examining the term and balloon risk impact of IO

Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

(cont.)

Chart 7: Size of 1.25 DSCR Loan At Various Coupons

Implied Loan Size as % of High Coupon Size

160% 150% 140% 130% 120% 110% 100% 90% 5.25% 6.25% 7.25% Coupon 8.25% 9.25%

loans with less leverage. Similarly, given the same beginning loan balance, it is possible to have a loan with an initial IO period that is equal in total risk to a higher coupon loan amortizing from day one. This is possible due to the faster amortization the low coupon loan provides. Over time, the low coupon partial IO loan can catch up to the amortizing high coupon loan and have the same balloon balance at maturity. Chart 6 shows the initial IO periods (in months) for the respective coupons that will provide the same balloon balance as the 9.25% coupon loan that amortizes from day one. As an example, the far right column in Chart 6 shows that a loan with a $1.0 million beginning balance and 44 month IO period (followed by a 30-year amortization schedule) will have the same balloon balance as a 9.25% loan with the same beginning balance and no partial IO period. All the loans have a similar balloon amount, so balloon risk is the same for each. Further, the partial IO loans have significantly higher DSCRs during the higher IO period and somewhat higher DSCRs during the amortization period. However, the average LTV over the term is greater for the partial IO loans as compared to the 9.25% loan since the outstanding balance is higher in each month (other than months 0 and 120, when they are the same). Again, it depends on how much term risk benefit one attributes to the higher DSCR, but it intuitively appears in some instances that the partial IO loans are at least similar in total risk to the 9.25% benchmark loan. CMM will be used later in the paper to quantify the relative risk of these loan structures.

Chart 8: CMM Output for Various Loan Structures and Changes in Property Value
Loan Coupon Rate Loan Structure: Standard base case loan amortizing from day 1 Add partial IO period but keep balloon balance equal to 9.25% base case loan Add leverage but keep balloon amount equal to 9.25% base case loan Add leverage but keep beginning DSCR equal to 9.25% base case loan 9.25% PD: 15.5% LGD: 38.0% EL: 5.9% PD: 15.5% LGD: 38.0% EL: 5.9% PD: 15.5% LGD: 38.0% EL: 5.9% PD: 15.5% LGD: 38.0% EL: 5.9% 8.25% 12.4% 37.8% 4.7% 12.6% 38.8% 4.9% 13.2% 38.5% 5.1% 17.5% 40.7% 7.1% 7.25% 9.9% 36.7% 3.6% 10.3% 39.2% 4.0% 11.3% 38.5% 4.4% 19.8% 52.9% 10.5% 6.25% 8.1% 34.8% 2.8% 8.4% 38.8% 3.3% 9.7% 38.1% 3.7% 22.5% 47.6% 10.7% 5.25% 6.7% 32.2% 2.2% 7.0% 37.6% 2.6% 8.4% 40.7% 3.4% 25.3% 51.4% 13.0%

Note: 1. Output shows cumulative probability of default (PD), loss given default (LGD) and expected loss (EL) for the respective mortgage coupon and loan structure. 2. Each loans refinance coupon assumption is 9.25% with a 360 month amortization schedule. 3. For Row 2, the partial IO periods are: 9.25% 0 months, 8.25% 11 months, 7.25% 23 months, 6.25% 34 months, and 5.25% 44 months.

BENEFIT OF LOW COUPON CAN BE ELIMINATED BY INCREASED LEVERAGE

Some borrowers take advantage of the DSCR benefit provided by lower coupons as an opportunity to seek even more leverage. A low coupon loan may still end up with an improved DSCR as compared to a higher rate loan, but the balloon amount can be greater than would be the case with a higher coupon loan. Earlier, Chart 1 illustrated how higher interest rates translate into lower loan proceeds. Similarly, the same dynamic provides additional proceeds with lower interest rates. In Chart 1, the 5.25% coupon loan implied a $1.0 million balance whereas the 9.25% coupon loan implied a $671,510 balance. This is nearly 50% more leverage. To further emphasize the power of loan coupons, Chart 7 shows the relationship between coupon and loan proceeds while keeping initial DSCR constant at 1.25. Looking at the far right of Chart 7, the 9.25% coupon implies an indicated loan size of 100% assuming a 1.25X DSCR. Moving to the left in the chart, the loan size increases as the coupon decreases (keeping the same cash flow and DSCR of 1.25x). All the way to the left, the 5.25% coupon corresponds to a loan size of nearly 150%. So, for the same property cash flow and DSCR, the 5.25% loan provides a nearly 50% larger initial loan balance than the

with the initial DSCR of 1.70 versus 1.25 is the better overall loan. Later in the paper, we will make some assumptions and CMM will quantify the relative risk of the loans.

IN SOME CASES, LOW COUPONS MAY ALLOW PARTIAL INTEREST ONLY PERIODS WITHOUT INCREASING TOTAL RISK
Partial IO loans are those loans with an initial period of interest only payments followed by another period of principal and interest payments. For example, a loan might be structured with interest only payments for the first three years and then have payments for the next seven years based on a 360-month amortization schedule. This structure has become fairly common, with about 25% of the average CMBS pool these days comprised of partial IO loans. It was shown earlier that lower coupon loans with more leverage could have the same total risk as higher coupon
40 CMBS WORLD

Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

(cont.)

high coupon loan. Illustrated earlier was the possibility of adding leverage to a low coupon loan and having overall risk be similar to a high coupon loan with less leverage. While this is theoretically possible, in practice some market participants push proceeds beyond what would equate the risk of the two loans. However, in spite of the additional risk resulting from more leverage, the low coupon does help to mitigate the leverage by providing faster amortization and a relatively higher DSCR.

FULL-TERM INTEREST ONLY LOANS

In contrast to the partial term IO loans just discussed, full-term IO loans do not have any principal payments until maturity. Without amortization, they will always have greater balloon risk than any amortizing loan of the same initial amount (at any coupon) with the same maturity date. They can, however, have much higher DSCRs as compared to higher rate amortizing loans. The higher coverage may imply better term risk, but can be offset by a higher average LTV over the term.

Each loan structure and respective coupon is run through the same property value scenario. In this study, the base case property is an office building in Houston, TX. The assumed occupancy and lease terms are calibrated to equal current market vacancy and average rents for the Houston market. Leases are assumed to expire every five years, so the property has 20% of its space rolling each year. Based on CMMs market projections, the propertys cash flow and valuation will change over time. While the chosen market has an impact on default probabilities and expected losses, the differences in PD, LGD and EL across the various loans will only be attributable to their specific structures since the same property scenario is used for each. All loans assume a refinance coupon of 9.25% and amortization schedule of 30 years. The refinance parameters drive the probability of default at maturity. Only one refinance coupon is used since the intention is to compare the relative risk of the various loan structures. This means we are not as interested in the nominal expected loss number as we are in which loans have greater expected loss relative to others. As illustrated earlier, one loan with lower balloon risk than another at a 9.25% coupon will also be relatively better at 10.25%, 8.25%, 7.25% or any other coupon. The purpose of Chart 8 is to compare the relative risk of the various loan structures. For example, is a 44-month partial IO structure at a 5.25% coupon more risky than a 9.25% coupon loan amortizing from day one? The table will help us answer such a question. The four different loan structures are listed on the leftmost side of Chart 8. The five columns to the right of the loan structure show the cumulative PD, LGD and EL for loans with initial coupon rates ranging from 5.25% to 9.25%. To address our sample question: is a 44-month partial IO structure at a 5.25% coupon more risky than a 9.25% coupon loan amortizing from day one? According to the table, the partial IO loan has an expected loss of 2.6% (see rightmost column in Row 2). The 9.25% coupon loan amortizing from day one has an expected loss of 5.9% (see leftmost column in Row 1). One of the first loan characteristics examined in this paper was the faster amortization provided by low coupon loans. Given this characteristic, and the fact that a lower coupon loan will have a better DSCR than a higher coupon loan, CMM should show better expected loss figures for the relatively lower coupon loans. Looking from left to right in Row 1 of Chart 8, we can see that expected loss does decrease with the lower coupon loans. Again, this is because given the same initial loan amounts, the lower coupon loans will have higher DSCRs and lower balloon amounts.
WINTER 2005 41

CMM QUANTIFIES RELATIVE RISK STRUCTURES

OF

SPECIFIC LOAN

The following analysis of loan structures utilizes Moodys CMM, a program designed to calculate the probability of default (PD), loss given default (LGD), and expected loss (EL) for commercial mortgage loans. Briefly, users can provide as input a host of details about an individual loan (e.g., coupon, amortization rate, existence of subordinate debt, and participation status) and an equally wide range of information about the property backing the loan (e.g., current rent levels, occupancy, lease roll-over schedule, and expenses). The output from the model includes the three major components of credit risk (PD x LGD = EL) for each year of the outstanding mortgage as well as other credit risk measures. More details about the model and the methodology that underlies it are available from Moodys. Chart 8 summarizes the CMM output for four specific loan structures each with coupons ranging from 5.25% to 9.25%. The four specific loan structures are: 1. A standard base case loan with a 1.25 DSCR, a 360 month amortization term and no IO period. 2. A loan where additional leverage is added up to the point where the balloon amount would be equal to that of the 9.25% base case loan. 3. A loan with a partial IO period the length of which results in a balloon amount equal to that of the 9.25% base case loan. 4. A loan with additional leverage added up to the point where the beginning DSCR is equal to 1.25X.

Interest Rates and IO Loans: An Analysis of Balloon and Term Risk

(cont.)

Earlier we showed that it may be possible to take advantage of the lower risk of low coupon loans (due to faster amortization and higher DSCR) to add a partial IO period and have the risk profile be at least equal to that of a benchmark 9.25% rate loan. The lower the coupon as compared to the 9.25% benchmark, the longer the partial IO period while still achieving the same balloon balance as the 9.25% benchmark loan. As we showed in Chart 6, the following initial IO periods are possible at each respective coupon rate: 8.25%11 months, 7.25% 23 months, 6.25%34 months, and 5.25%44 months. Row 2 shows the CMM output for these loans. The expected losses for the partial IO loans with coupons between 5.25% and 8.25% are actually lower than the expected loss for the 9.25% benchmark loan amortizing from day one. Again, this is due to the fact that all loans have the same balloon balance (implying same balloon risk), but benefit from lower term risk due to higher DSCRs. However, at each rate below 9.25%, expected losses are higher than for the benchmark loan (Row 1) with the same interest rate. This is because the average LTV of the partial IO loan over the term is higher than the respective benchmark loan with the same rate. Similar to adding a partial IO period to a lower coupon loan to take advantage of its faster amortization and higher DSCR, we can instead keep the balloon amount constant and add leverage. In our example, we raised leverage to a point where the Year 10 balloon balances for our low coupon loans would be equal to the Year 10 balloon balance of the benchmark 9.25% loan. Row 3 of Chart 8 shows the CMM output for these loans. Similar to the results for partial IO loans, the expected losses for the higher leveraged loans with coupons between 5.25% and 8.25% are all less than the expected loss for the 9.25% benchmark loan (Column 1, Row 1). This is due to the term risk benefit provided by higher DSCRs with respect to the lower coupon loans. All the loans in Row 3 have the same balloon amount as the 9.25% benchmark loan and therefore have the same balloon risk. Therefore, the difference in expected loss must be attributable to the term risk benefit of the higher DSCR. As was the case with the partial IO loans, at each rate below 9.25% expected losses are higher than for the benchmark loan (Row 1) with the same interest rate. Again, this is due to the higher average LTV over the loan term. In Row 4, the expected losses for each loan in the 5.25% to 8.25% range are higher than for any other loan structure in the table. This row shows the CMM output for loans where leverage is increased up to a point where a 1.25X DSCR is maintained. Here, the 5.25% loan has nearly 50% more initial leverage as compared to the 9.25% benchmark loan. Although coverage is the same at 1.25X, the average LTV throughout the term and at balloon is considerably higher than the 9.25% base case.

Clearly, low coupon loans can support additional leverage as well as partial IO periods and have similar total risk profiles as high coupon loans amortizing from day one. What sometimes happens in practice, however, is that new loans are made at leverage levels beyond that which equates the total risk between the two loans. As illustrated in Row 4, the DSCR benefit provided by low coupon loans allows significant additional debt to be added while keeping DSCR constant (at 1.25X in our examples), and can result in a significantly higher risk profile.

SUMMARY
With the growing prevalence of IO loans (both partial and full term), many market participants have grown concerned about the credit implications of such structures, especially in light of very low coupon rates on new loans. Refinance risk at maturity is a common topic of discussion these days. This article set out to put the term and balloon risk of these loans into perspective. Much of our analysis involved comparing various loan structures and leverage levels to a base case loan with a 9.25% coupon. We showed early on the impact that coupon has on the loan proceeds that property cash flow can support at given coverage levels. To highlight the significance of balloon risk to changing interest rates we explained that a 200 basis point increase in mortgage coupon would be enough to prevent the refinancing of the balloon amount ten years later assuming that property cash flow remained constant. An important characteristic of coupon rate is that lower coupon loans amortize relatively faster than higher coupon loans. This implies that low coupon loans have lower balloon risk than high coupon loans with the same beginning balance. Additionally, the low coupon loans of the same initial principal amount have better DSCRs and hence better term risk. If low coupon loans have better overall risk than high coupon loans, then it follows that some credit negative changes (such as additional leverage and partial IO periods) could be added to the low coupon loan to bring its total risk profile in line with the high coupon benchmark loan. We showed, through simple examples and the use of CMM, how much additional leverage or length of partial interest only periods could be added while still keeping total risk comparable to that of our benchmark loan. Some loans made today, however, add leverage beyond what would make the loans comparable to the total risk of the benchmark loan. Moodys recognizes the benefits that low coupon loans can provide but is mindful of total leverage increasing to a level that negates these benefits.

Sally Gordon is Vice President, Senior Analyst, at Moodys Investors Service. Paul Staples, Citigroup Global Markets, was formerly with Moodys Investors Service.

42 CMBS WORLD

WINTER 2005

43

Lodging Revisited: Hospitality Sector is On the Mend

Kim Betancourt, Peter P. Kozel and Michael J. Magerman
For the past few years, and especially since 9/11, the lodging industry has suffered from a downturn in tourism and business travel. As a result, hotel loans have been among the worst performing property types in commercial mortgage-backed securities (CMBS) transactions. We recently revisited this property type to see just how bad loss severities have been since Realpoints CMBS Loss Severity Study of May 2003. It turns out that while there has not been a meaningful change for the better in hotel loan loss severities since the end of 2002, at least things havent been getting any worse. As a matter of fact, there are a number of indications that conditions are actually on the mend. The number of hotel loans incurring losses increased dramatically in 2003 and 2004a total of 122 loans in that period compared to 73 loans for the period of 1996 through 2002. With 15 loans incurring losses, Texas had the highest number of liquidated loans. Orlando saw the highest liquidated loan amount at $83.6 million. Greenville, SC suffered the highest loss severity percentage at 87.1%. Surprisingly, there was no significant difference in severity between limited service and full service property types. Unsurprisingly, there were relatively few hotel loans in CMBS issued from 2000 through 2004. One important note: while it appears that the loss severity amounts for hotels improved significantly from our May 2003 Loss Severity Study, the 2003 and 2004 numbers are heavily influenced by one very large loan in each year. Excluding those two large loans, which were both resolved incurring very small losses, the average severities are actually about 10 percentage points higher. For 2003, the aggregate loss severity jumps to 52.3% from 42.3%. For 2004 through July, the severity increases to 46.7% from 36.5%.

Betancourt

Kozel

Industry participants are nearly unanimous in their assertions that overall hotel market conditions Magerman have greatly improved since the beginning of 2003. There is much statistical support for this in terms of improved occupancy and room rates. In addition, lenders and other market observers are saying that interest in investing in hotels has recovered strongly over the past year and a half. We analyzed 122 defaulted hotel loans that totaled $716.4 million in remaining balances at the time of liquidation from January 2003 through July 2004. Here are some key observations: Loss severities for hotel properties for 2003 stood at 42.3%down from 50.28% for the period of 1996 through 2002. Hotel loss severities for the first seven months of 2004 are even lower at 36.5%. Average loan size at liquidation was fairly small at $5.9 million.
44 CMBS WORLD

HOTEL DELINQUENCIES DECLINING

Weve been noticing the improvement in the performance of the CMBS hotel loan sector since the end of 2003. As reported in our Monthly Delinquency Report, the universe of CMBS hotel loans had a delinquency rate of more than 5% for much of 2003. And thats up from having ended 2002 at 4.84%. As reflected in Chart 1, hotel delinquency peaked during the third quarter of 2003, reaching 5.54% in August, and remained high at 5.24% in December 2003. But 2004 saw a big improvement. Due to better loan performance and the substantial number of liquidations in the first seven months of 2004, the delinquency rate fell to just 2.81% by July 2004.

Lodging Revisited: Hospitality Sector is On the Mend

(cont.)

Chart 1: CMBS Defaulted Hotel Loan Resolutions, January 2003 July 2004 (Dollars in Millions)
Month, Year 2003 January February March April May June July August September October November December 2004 January February March April May June July 2003 2004 through July Total
Source: Realpoint

Number of Loans 5 5 6 8 9 7 9 3 2 6 3 9 5 8 7 7 11 6 6 72 50 122

Balance at Liquidation $13.94 $16.47 $15.53 $37.77 $52.46 $36.93 $36.07 $95.58 $10.29 $33.89 $15.87 $49.45 $45.09 $33.49 $22.48 $22.98 $50.72 $31.37 $96.04 $414.25 $302.16 $716.41

Dollar Losses $4.28 $9.89 $8.91 $16.88 $35.45 $3.62 $19.50 $10.79 $9.75 $19.94 $12.08 $24.25 $10.19 $21.38 $16.87 $15.45 $24.03 $13.45 $8.82 $175.35 $110.19 $285.54

Percentage Losses 30.70% 60.10% 57.40% 44.70% 67.60% 9.80% 54.10% 11.30% 94.80% 58.90% 76.10% 49.00% 22.60% 63.80% 75.10% 67.20% 47.40% 42.90% 9.20% 42.30% 36.50% 39.90%

There has been a marked shift in changes in occupancy for the Monday through Thursday period. Why is this important? Because thats when most people are traveling on business. And the business traveler is one of the lodging sectors most important customers. During the first eight months of 2002, every day of the week had a decline in average occupancy from the previous year. The largest declines centered in the Tuesday through Thursday business travel period. The daily declines ranged from 3.6% to 4.5%. This year things took a dramatic turn for the better. For the same period in 2004, the change in occupancy looks like the mirror image of 2002, with increases roughly the same size as the declines seen during 2002. The 2004 daily increases for Tuesday to Thursday ranged from 3.3% to 5.4%. Following two years of declining room rates in 2001 and 2002, and essentially no change in 2003, ADR is forecasted to increase 3.5% this year. And its expected to get even betterup 3.8% in 2005. Aiding in this recovery is a slowing of additional supply of new rooms. The pace of hotel construction slowed dramatically during 2002 and eased further in 2003. Only this year did the pace increase again, but through August remained well below where it had been in the first half of 2002.

1996-1998 ISSUANCE YEARS ARE THE USUAL SUSPECTS

As noted in Chart 2, it is not surprising that 111 of the 122 loans came from CMBS transactions issued prior to 2000. Thats because the percentage of hotel loans in new transactions dropped precipitously after 9/11. Looking at the vintages from which the liquidations of 2003 and 2004 came, more than half of the loans were from deals issued in 1997 and 1998. In those years, it was not uncommon for conduit transactions to contain 10% or more hotel loans. The 1998 deals produced 39 of the 122 liquidated loans in our study. This is not unexpected, as the early peak issuance year of 1998 remained in first place until it was finally surpassed in 2003. The issuance period 1996 through 1999 produced 104 of the 122 loans. Loans from deals issued in 1996 through 1998 had loss severities averaging anywhere from 50% to 60%. There was a slight drop to about 45% for loans from the 1999 deals, and a significantly smaller average loss for the 11 loans from the 2000 and 2001 vintage deals. The number of hotel loans incurring losses increased dramatically in 2003 and 2004 a total of 122 loans in that period compared to 73 loans for the period of 1996 through 2002. This is consistent with the general acceleration in number of liquidations experienced since 2000, and may owe in part to the efforts of some special servicers to delay
WINTER 2005 45

Chart 2: CMBS Defaulted Hotel Resolutions, January 2003July 2004 (By Year of CMBS Issuance, Dollars in Millions)
Issuance Year 1995 * 1996 1997 ** 1998 1999 2000 2001 Total Number of Loans 6 17 28 39 19 7 4 120 Balance at Liquidation $18.25 $74.54 $79.53 $210.57 $76.42 $69.10 $30.16 $558.57 Dollar Losses $11.34 $40.36 $39.40 $124.91 $34.68 $18.48 $9.67 $278.83 Percentage Losses 62.10% 54.10% 49.50% 59.30% 45.40% 26.70% 32.10% 49.90%

* Excludes one very large loan which represents 83% of years total balance and had loss severity of 7%. ** Excludes one very large loan which represents 46% of years total balance and had loss severity of 0.6%. Source: Realpoint

LODGING SECTOR SEEING IMPROVING TRAVEL TRENDS

Aside from lower loan delinquencies, there are numerous indications that conditions within the lodging industry are on the upswing. Smith Travel Research shows that overall U.S. midweek occupancy has improved by roughly 4% over last year through August 2004. The average daily rate was up 3.8% through July 2004. And weekday travel was up as well, with the average daily rates (ADR) up 3.7% on weekdays.

Lodging Revisited: Hospitality Sector is On the Mend

(cont.)

Chart 3: CMBS Defaulted Hotel Loan Resolutions, January 2003 July 2004 (By State, Dollars in Millions)

State Alabama Arizona California Colorado Florida Georgia Illinois Indiana Iowa Kansas Kentucky Louisiana Massachusetts Michigan Minnesota Mississippi Missouri Nebraska Nevada New Mexico New York North Carolina Ohio Oklahoma Oregon Rhode Island South Carolina Tennessee Texas Utah Virginia Various Total
Source: Realpoint

Number of Loans 1 7 2 5 11 9 1 5 2 1 2 3 1 2 1 1 3 2 2 1 2 12 3 2 3 1 7 4 15 1 6 4 122

Balance at Liquidation $1.72 $24.02 $23.72 $23.87 $121.68 $25.65 $1.42 $14.11 $3.85 $2.61 $5.51 $11.93 $16.23 $11.82 $3.54 $2.32 $13.58 $6.68 $10.01 $2.79 $69.13 $31.85 $9.66 $18.71 $18.47 $3.63 $31.34 $11.11 $51.71 $2.59 $34.84 $106.31 $716.41

Dollar Losses $1.17 $11.44 $3.59 $9.69 $57.24 $14.09 $0.39 $7.82 $1.92 $1.40 $4.81 $8.37 $6.72 $4.80 $2.02 $0.89 $10.45 $2.68 $6.47 $1.44 $0.41 $13.55 $6.68 $2.96 $9.89 $1.54 $23.09 $5.33 $28.48 $2.48 $13.09 $20.67 $285.54

Percentage Losses 67.60% 47.60% 15.10% 40.60% 47.00% 54.90% 27.50% 55.40% 50.00% 53.50% 87.20% 70.20% 41.40% 40.60% 57.10% 38.30% 76.90% 40.10% 64.60% 51.60% 0.60% 42.50% 69.10% 15.80% 53.50% 42.30% 73.70% 48.00% 55.10% 95.80% 37.60% 19.40% 39.90%

Chart 4: CMBS Defaulted Hotel Loan Resolutions, January 2003 July 2004 (MSAs with Over $5 Million Liquidated Loans Only, Dollars in Millions)
MSA Greenville, SC Reno, NV Savannah, GA Wilmington, NC Kansas City, MO Evansville, IN Cincinnati, OH Orlando, FL Charleston, SC Lynchburg, VA El Paso, TX Charlotte, NC Portland, OR Austin, TX Phoenix, AZ Denver, CO Boston, MA Detroit, MI San Jose, CA Dallas, TX Memphis, TN Omaha, NE Atlanta, GA Raleigh, NC Norfolk, VA Oklahoma City, OK Los Angeles, CA Miami, FL New York, NY Total for MSAs above
Source: Realpoint

Number of Loans 4 1 3 1 2 2 2 8 2 2 3 4 3 2 6 3 1 2 1 5 3 3 5 3 2 2 1 1 1 78

Balance at Liquidation $14.92 $7.51 $9.29 $7.28 $7.42 $5.68 $7.11 $83.65 $14.02 $7.39 $5.96 $6.46 $18.47 $12.30 $22.82 $18.14 $16.23 $11.82 $6.29 $16.31 $10.22 $8.25 $13.89 $9.73 $20.80 $18.71 $17.43 $30.51 $66.83 $495.43

Dollar Losses $13.00 $6.19 $7.33 $5.57 $5.22 $3.90 $4.81 $52.96 $8.22 $4.28 $3.45 $3.64 $9.89 $6.50 $10.77 $7.85 $6.72 $4.80 $2.48 $6.42 $3.83 $3.03 $4.52 $2.68 $5.50 $2.96 $1.11 $0.32 $0.38 $198.31

Percentage Losses 87.10% 82.40% 78.90% 76.40% 70.40% 68.70% 67.60% 63.30% 58.60% 57.90% 57.90% 56.40% 53.50% 52.80% 47.20% 43.30% 41.40% 40.60% 39.40% 39.30% 37.40% 36.70% 32.60% 27.60% 26.40% 15.80% 6.40% 1.10% 0.60% 40.00%

some resolutions until market conditions turned more favorable.

NO APPRECIABLE DIFFERENCE BETWEEN SERVICE TYPES

Interestingly, there does not appear to be a statistically significant effect of the service type of hotels with the level of loss severity experienced. For loans which had a clear indication of the level of service, full service hotels had an aggregate loss severity of 53%. This is excluding the $66.8 million loan on the Paramount Hotel in Manhattan. This loan sustained a minor loss of only 0.6%. In comparison, limited service hotel loans had a slightly lower loss severity of 51%. While this seems counter-intuitive, statistically there is no real difference in loss severity amounts.

Commercial Mortgage Corp.s hospitality lending unit, lenders see a real correlation between growth in GDP and improvement in the lodging sector. And this seems to be holding true so far this year. For example, during the week ending August 28, occupancies were at 64.4%, showing an increase of 2.7% compared to the same period last year, Smith Travel Research indicated. For the same period, ADR was up by 4.3% at $84.41 compared to last year and revenue per available room (RevPAR) was at $54.41, experiencing an increase of 7.1%. GMACs Lowrey states that hotel construction lending remains a niche business. Hotel lenders not only need a strong balance sheet, but need to have patience. It could easily take up to five years from putting the shovel in the dirt to seeing positive cash flow develop on a number of hotel properties. These are certainly not the types of loans that conduit issuers want to have in CMBS transactions. Lowrey also believes that more mixed-use hotel properties will be seen in these larger metro areas. Properties that provide

ECONOMIC IMPROVEMENT IS BEING FELT THROUGHOUT HOTEL INDUSTRY

According to Bruce Lowrey, Vice President of GMAC
46 CMBS WORLD

Lodging Revisited: Hospitality Sector is On the Mend

(cont.)

Chart 5: CMBS Defaulted Hotel Loan Resolutions, January 2003 July 2004 (By Original Flag with Over $20 Million Liquidated Loans Only, Dollars in Millions)
Flag Best Western Comfort Inn Days Inn Hampton Inn Holiday Inn Hyatt Ramada Residence Inn Sheraton
Source: Realpoint

Chart 6: Hotel Stock and Forecast New Supply 25 Major Hotel Markets

Number of Loans 14 13 10 3 22 1 8 2 3

Balance at Liquidation $58.33 $37.35 $25.77 $25.17 $89.60 $20.04 $39.02 $24.16 $24.08

Dollar Losses $26.76 $23.39 $12.91 $15.34 $57.94 $5.06 $23.03 $7.30 $12.60

Percentage Losses 45.90% 62.60% 50.10% 60.90% 64.70% 25.20% 59.00% 30.20% 52.30%

MSA Atlanta, GA Boston-Worcester, MA-NH Chicago, IL Dallas-Ft. Worth, TX Denver, CO Detroit, MI Honolulu, HI Houston, TX Los Angeles-Long Beach, CA Miami, FL Minneapolis-St. Paul, MN-WI Nashville, TN New Orleans, LA New York, NY Norfolk-Virginia Beach, VA Orange County, CA Orlando, FL Philadelphia, PA-NJ Phoenix-Mesa, AZ San Diego, CA San Francisco, CA Seattle-Bellevue-Everett, WA St. Louis, MO-IL Tampa-St.Petersburg, FL Washington, DC-MD-VA-WV Total for 25 markets
Sources: PPR, F.W. Dodge

Hotel Room Supply 4th Quarter 2003 85,939 45,260 83,702 91,224 36,515 37,293 37,277 52,801 93,897 46,734 32,329 36,265 31,038 71,721 38,964 53,663 134,165 37,336 58,275 60,336 48,842 39,737 31,643 41,771 80,985 1,407,712

Forecast New Supply Next 12 Mos. 647 1,859 1,439 1,401 1,807 231 25 1,099 333 1,561 245 83 619 1,172 1,256 251 863 529 614 1,321 485 353 961 694 2,955 22,803

% Supply Growth 0.80% 4.10% 1.70% 1.50% 4.90% 0.60% 0.10% 2.10% 0.40% 3.30% 0.80% 0.20% 2.00% 1.60% 3.20% 0.50% 0.60% 1.40% 1.10% 2.20% 1.00% 0.90% 3.00% 1.70% 3.60% 1.60%

both a mix of some hotel rooms as well private condo units for more wealthy owners will certainly become the hotel property of choice in most of the larger, key metro markets, such as New York City, San Francisco and Washington, D.C. As a result of the relatively strong fundamental performance, hotel landlords have stayed out of trouble with lenders. Mark Gordon, Managing Director and Principal at Sonnenblick-Goldman, which arranges hotel debt and equity transactions, believes that although the market for hotel loans has been competitive, lenders have still been relatively rational. In general, lenders have become more scrutinizing and operators have become more discerning, he noted. That said, Gordon believes that competition on the investment side has made both lenders and investors more aggressive and exposed the industry to greater risk once again. In fact, U.S. hotel transaction activity saw the most activity since the late 1990s, with single-asset hotel deals doubling to $7.3 billion in the first half of 2004, according to a recent report from Jones Lang LaSalle Hotels. The report noted that 58 transactions above $10 million, with an average price per key of $100,698 in the first half of 2004 were completed. The robust deal flow reflects the amount of capital re-emerging into the hotel sector, noted Gordon. On the debt side, it is believed that many of the loans being originated are from new players including pension funds and insurance companies that have been in large part shut out of placing equity and need to put cash to work. Theres just a more competitive environment out there now and it has forced yields to compress, which in turn has led to lower returns for some borrowers, Gordon said. Eighteen months ago there were eight lenders, now there are about 30. Gordon also believes that lenders have not been overly anxious providing construction debt because yields have

not been adequate. [Lenders] are going to have to be a bit more creative on their lending. When you have loans at LIBOR plus 200, thats not much of a spread, he said. Construction financing is still limited but will be more prevalent over the next six months, he speculated. Gordon envisions that much of the growth will occur in markets such as New York and Washington, D.C., where many hotels have been or will be converted into rental residences or condominiums. These areas can actually use some new hotels.

OPTIMISM EXPRESSED FORECASTER

BY

LEADING INDUSTRY

As leisure and business travel are on the uptick and new construction modest, the overall hotel market has been reaping the rewards with most industry players expressing an optimistic outlook for the remainder of the year and into 2005. At this point, 2004 is shaping up to be a pretty good year performance-wise and we expect that it will continue to do well into the coming year, said Bobby Bowers, Senior Director of Operations at Smith Travel Research. The Hendersonville, TN-based data provider expects to see growth in average daily room rates of 6%.
WINTER 2005 47

Lodging Revisited: Hospitality Sector is On the Mend

(cont.)

Industry participants are nearly unanimous in their assertions that overall hotel market conditions

Other markets in the Southeast with high loss severities included Greenville, SC, which had 87% losses on four liquidations, and Savannah, GA with 79% on three liquidations. There were some markets that had several liquidations but with mixed levels of loss severity. For example, Phoenix had six liquidations with 47% severity, Dallas had five with 39%, Atlanta had five with 33%, and Charlotte had four with 56%.
Effect of Flags on Loss Severity

Although it projects ADR growth of 6% for the following year, the estimates represent an even higher rate of improvement than the 4.5% in ADR growth Smith Travel had predicted at the beginning of the year. Really, the growth depends in large part on what the economy looks like but forecasts for gross domestic product this year are at 4%. And while thats not great, thats still pretty good, if it holds up, Bowers added.

Construction debt, however, has been more difficult to come by, according to Bowers, noting that overall hotel construction is down on a historic level. Traditionally, the hotel market has seen a 2% to 2.3% increase in rooms and only 1% growth is expected this year, he said. A little less than 90,000 new rooms are being built. Right now, evidently the financing is still a bit tight for lenders.

SOUTHERN STATES SEE DISPROPORTIONATE SHARE LOSSES

OF

As highlighted in Chart 5, there were nine prominent brands which accounted for $20 million or more of total liquidated loan balance, and roughly 48% of the total balance and 65% of the $285 million in losses. These included budget-oriented brands such as Comfort Inn and Days Inn, and also included brands ranging from Holiday Inn to Hyatt and Sheraton. Six of the nine chains had loss severities of 50% or higher, with Holiday Inn topping the list at 64.7%. Not surprisingly, the 22 Holiday Inn liquidations involved 15 properties in states in the Southeast and Texas. Comfort Inns 13 liquidations were similarly concentrated, while Best Westerns 14 were more widely distributed across the U.S.

The hotel sector suffered losses in most states across the U.S. As seen in Chart 3, although Utah saw the highest loss severity at 95.8% on its only liquidated loan, it was the southern portion of the country that revealed a pattern of high losses. Excluding Texas, ten Southeastern states accounted for 56 of 122 liquidations, totaling 39% of remaining balance and 50% of all losses. Some of the harder hit southern states included Kentucky at 87.2%, South Carolina at 73.7% and Louisiana with 70.2%. Texas, which accounted for 15 liquidated loans, also accounted for 10% of all dollar losses and had a loss severity of 55.1%.

FUTURE TRENDS

FOR

CMBS HOTEL LOANS

With the next wave of hotel liquidations coming primarily from real estate owned (REO) properties, we expect to see 2004 follow a similar pattern to that of the past year. Realpoints database lists 2,247 hotel loans with an average balance of $13.7 million. Of that universe, there are 125 loans categorized as 90 or more days delinquent, in foreclosure or REO with a total balance of $670 million. That translates to 2.17% of the total hotel loan balance. Of the 19 loans currently in foreclosure, four of the seven largest collateral properties are in the Orlando-Kissimmee area. Of the 48 REO properties with an average balance of $6.4 million, 18 are in states in the Southeast and seven others are in Texas. Of the three largest properties in terms of remaining balance, which account for 32% of the REO total, two are in the Orlando area and the other is in the Cayman Islands.

LARGER METRO MARKETS HELD UP

At the MSA level, there were too few occurrences of liquidations on which to base any real statistical significance, but the concentrations of occurrences point out some interesting patterns. The 29 MSAs noted in Chart 4 represent 69% of the losses in our universe of 122 hotel loan liquidations. The other 34 MSAs not listed account for 31% of the losses A few metros had loss severities that were well above the national average. Orlando had eight liquidations, which is the most of all the metros. It also had the highest dollar balance of liquidated loans at $83.65 million. Its loss severity of 63.3% is not surprising in the context of what we know about the very difficult conditions faced by Orlando hotels in 2002 and 2003.
48 CMBS WORLD

WHATS

ON THE

HORIZON

FOR

HOTELS?

We expect to see continued improvement in the CMBS hotel sector over the rest of 2004 and into 2005. Chart 6 notes that forecasted new supply is healthy at an overall 1.6%, but not excessive. Absent shocks to air travel such as experienced in 2001, the hotel market recovery should result in moderate loss severities as the current universe of delinquent and foreclosed hotel loans is liquidated.
(continued on p. 56)

WINTER 2005

49

FDIC Closes the Books on RTC Securitization Program

George Alexander and Tom Raburn
With the termination of the last Resolution Trust Corporation (RTC) securitization transaction in 2004, the FDIC has had an opportunity to evaluate the history and final results of the securitization program. Beyond the numbers, one of the most significant legacies of the RTC program was the prominence and major contributions made in the development of the commercial mortgage-backed securities (CMBS) market. each group supporting a specific class or classes of securities. The diversity of RTC collateral, combined with the need to dispose of assets quickly and efficiently, was the driving force behind the complexity of the transaction structures. Because the RTC MBS transactions were not backed by the full faith and credit of the U.S. government, credit enhancement was provided with reserve funds, excess interest, and representations and warranties on each deal. Credit reserve levels varied depending on the collateral and deal structures, but averaged 13.3% of original certificate balances for the single family transactions and 26.0% of original certificate balances for the multi-family and CMBS transactions. For the single family transactions, the MBS servicer was typically required to make all advances associated with delinquencies and REO (real estate owned). Advances were recoverable from disposition proceeds, and the realized loss amount was drawn from the reserve fund to make the Trust whole. In the multi-family and CMBS program, all advances and losses were funded monthly from the reserve funds. Though a final realized loss accounting was required of the MBS servicer on asset disposition, the MBS servicers were not required to make out-of-pocket advances. Another key element of credit enhancement was excess interest. There were significant amounts of excess interest in the RTC securitizations, and in most deals it was used to accelerate the payment of the subordinate security classes and create overcollateralization as an additional cushion against losses. The build-up of overcollateralization in each deal ultimately resulted in significant residual distributions to the FDIC at the termination of each Trust. Representations and warranties were also an important component of the RTC deals. Because the loan pools for each transaction were generally aggregated from multiple originators, each of which had failed, there were greater than normal concerns regarding document deficiencies and collateral quality. To alleviate these concerns, the RTC provided representations and warranties which covered most aspects of the loans, the properties, and the documentation. For the commercial transactions, the RTC also provided an environmental indemnification. In the

Alexander

The RTC existed from August 1989 through December 1995 and was established by Congress as a temporary federal agency to clean up the savings and loan crisis. As conservator and receiver of insolvent thrifts, the RTC managed the liquidation of $402.6 billion in assets, of which approximately $193 billion, or 48%, represented residential, multi-family and commercial mortgage loans, the largest single category of assets in the RTCs inventory.
Raburn

The RTC initiated a private securitization program in December 1990 to broaden the base of investors, enhance recoveries and expedite sales of loans. From June 1991 to December 1995, the RTC closed 40 single family and 27 multi-family and commercial mortgage securitizations involving almost 500,000 assets with book values exceeding $41 billion. Assets liquidated via securitization accounted for over 10% of all RTC asset liquidations and 21% of all mortgage liquidations. At the end of 1995, the FDIC assumed the oversight and management responsibilities associated with the RTC transactions.

OVERVIEW TRANSACTION STRUCTURES PROGRAM RESULTS

Transaction Structures

AND

The RTC transactions were structured as sequentially subordinate, multi-class pass-through. The RTC retained the residual interest in each series. Many transactions included both fixed and adjustable-rate collateral components that were divided into multiple loan groups,
50 CMBS WORLD

FDIC Closes the Books on RTC Securitization Program

(cont.)

Chart 1: Losses and Claims Paid (Dollars in Millions)

As a % of Initial Collateral Collateral Type Single family Multi-family & CMBS Total
Source: FDIC

Aggregate losses paid from the reserve funds and representation and warranty claims paid, by transaction type, are presented in Chart 1. Investor losses were incurred on one transaction, Series 1991-M2. This was a multi-family transaction with 100% of the collateral in California. Losses fully depleted the credit reserve fund, and approximately $5 million in interest due to the subordinate certificateholders was diverted to make required payments to senior holders. Following the termination of each transaction, the FDIC performed a final pricing analysis in which all cash flows directly attributable to the deal were discounted to present value as of the original issue date. All cash flows were discounted at the governments cost of funds. The resulting discounted cash flow figure was compared to the estimated whole loan sales value provided by the financial advisor at the time of closing, as adjusted for estimated disposition costs. Based on this analysis, the securitization program generated $3.5 billion in additional proceeds to the U.S. government. The net return as a percentage of collateral sold was 97.3%, or 860 basis points higher than the estimated whole loan sales values. Chart 2 summarizes these results.

UPB Sold $24,398 $16,983 $41,381

Original Reserve Fund 13.3% 25.9% 18.5%

Cumulative Losses 2.0% 7.8% 4.4%

Repurchase Other Claims Claims Paid Paid 0.2% 3.7% 1.6% 1.0% 0.5% 0.8%

Chart 2: Final Pricing Analysis (Dollars in Millions)

As a % of Initial Collateral Collateral Type Single family Multi-family & CMBS Total
Source: FDIC

UPB Sold, Net of Repurchases $24,355 $16,359 $40,714

Discounted Securitization Cash Flow 100.2% 93.1% 97.3%

Max Est. Whole Loan Value 94.8% 79.7% 88.7%

As % of Par 5.4% 13.4% 8.6%

Amount $1,318 $2,185 $3,503

event of a breach, the RTC was required to cure the breach or cover any monetary loss or expense incurred and had the option of repurchasing a loan that was the subject of a breach.
Industry Impact and Final Program Results

LEGACY

OF THE

RTC CMBS PROGRAM

The RTC securitization program began with the issuance of RTC Series 1991-1 in June 1991. From that date through September 1995, the RTC issued 40 single family transactions and 27 multi-family and CMBS transactions involving the sale of over $41 billion in assets. Issuance involved all the major Wall Street firms and rating agencies, as well as many law firms and accounting firms. Sixteen MBS servicers and five trustees were engaged for ongoing transaction servicing and support. Due to its continuing interest in the transactions as owner of the pledged reserve funds and residual certificates, the RTC established an MBS Administration Unit which was folded into the FDIC upon the RTCs sunset. The MBS Administration Unit monitored transaction performance throughout the life of each series and was responsible for servicer and trustee oversight. The transactions generally provided for call and termination at either 25% of the original certificate balance or 10% of original collateral for the single family transactions, and at 10% of original certificate balance for the multi-family and CMBS transactions. The first transaction to reach the call level was Series 1991-7, which terminated in February 1997. Series 1995-2 was the last transaction to terminate in March 2004.

One of the most significant legacies of the RTC securitization program was the prominence it played in the development of the private CMBS market. Because commercial mortgages were riskier and lacked the homogeneity of residential mortgages, commercial securitizations completed before 1990 were private placements issued by commercial banks and life insurance companies. At that time, the market amounted to about $6 billion. Structures were simple, involving the issuance of one or two tranches of rated certificates that were secured by a small number of commercial properties. Investors were primarily those that had a considerable level of commercial real estate expertise and were able to conduct their own property-specific analysis. The RTC greatly expanded the market by creating unique and complex securitization structures to sell its large inventory of commercial and multi-family loans. This was a hard sell at the inception of the program, however, because massive loss of value in commercial mortgages was a major contributor to the thrift and bank failures of the late 1980s and early 1990s, and the sector remained highly suspect. Key elements to the success of the RTC securitization program and acceptance of the CMBS product were: Providing the credit enhancement necessary to secure initial investor acceptance.
WINTER 2005 51

FDIC Closes the Books on RTC Securitization Program

(cont.)

Chart 3: Initial Reserve Levels RTC CMBS Transactions

Bringing a steady volume to market over a prolonged period. Innovation in the evolution of transaction structures, servicing and reporting. Facilitating transaction performance through a servicer and trustee oversight program. The evolution of RTC CMBS was rooted in the original CMO (collateralized mortgage obligation) pass-through structures used in the residential MBS market. However, because of the diverse characteristics of RTC collateral, these structures were inevitably transformed into what were then regarded as very unique and complex transactions. A number of transaction features were considered firsts in the market, including: Multiple loan groups and multiple certificate classes, with both fixed-rate and adjustable rate components. Multiple asset types and originators.

0.35 0.30 0.25 0.20 0.15 0.10 0.05 0

F 8 C1 C2 C3 C1 C2 C1 C2 1 C2 C3 C4 C5 C6 C7 -C CH -C 2- 92 93 93 93 94 94 95 95 92 92 92 92 92 92 92 19 19 19 19 19 19 19 199 19 19 19 19 19 19 19 19

Initial Reserve

Source: FDIC

Chart 4: Initial Reserves and Cumulative Losses as a Percentage of Initial Collateral RTC CMBS Transactions
0.35 0.30 0.25 0.20 0.15 0.10 0.05 0
F 8 C1 C2 C3 C1 C2 C1 C2 1 C2 C3 C4 C5 C6 C7 -C CH -C 2- 92 93 93 93 94 94 95 95 92 92 92 92 92 92 92 19 19 19 19 19 19 19 199 19 19 19 19 19 19 19 19

Large pool sizes, both by number of loans and aggregate balance. Basis risk. Special servicers for delinquent and troubled assets. Provisions allowing for increased loan modification flexibility. Development of Portfolio Performance Reports, the precursor to CMSA reporting standards. It was the unique features of these transactions that caused the initial concern in the market over the viability of RTC CMBS. Equally problematic, however, was the lack of adequate information on the underlying collateral and uncertainty regarding origination standards and the quality of servicing. These issues, coupled with generally lower quality real estate than previously seen in the capital markets, resulted in what was then the highest credit support ever assessed for commercial mortgage pools, encompassing both high levels of reserve funds and extensive representations and warranties. These features proved vital in enabling the rating agencies to rate the RTC transactions, as well as to the markets acceptance of the securities as viable investments. For the first transaction, Series 1991-M1 issued in August 1991, the reserve fund amounted to 35% of certificates issued. The RTC issued ten additional multifamily series from September 1991 through May 1992, and the initial reserve levels ranged from 25% to 30% with an

Initial Reserves

Cumulative Losses

Source: FDIC

Chart 5: Initial Reserves and Cumulative Losses as a Percentage of Initial Collateral RTC Multi-Family Transactions
0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0
1M 19 9
19 19 19 19 19 19

Initial Reserves

Cumulative Losses

Source: FDIC

52 CMBS WORLD

19 9

91

91 19

91

91 19

92

92

92

2M

-M

-M 91 19

-M

-M 91

-M

-M

-M

-M

-M

FDIC Closes the Books on RTC Securitization Program

(cont.)

average of 28.1%. The first CMBS transaction was issued in February 1992 with an initial reserve level of 30%. Chart 3 presents the initial reserve levels for the CMBS transactions, and shows a substantial decrease with the issuance of 1992-CHF. This decrease corresponded with the introduction of the first non-investment grade tranche, which was rated double-B. A single-B tranche was introduced with Series 1995-C1. During the life of the program, key innovations were made to improve the quality of servicing and maximize asset return. A significant development was the division of servicing functions between a master servicer and special servicer, with the special servicing function created to manage delinquent loans and REO. The addition of the special servicer was intended to ensure servicing of delinquent assets by an entity that was highly experienced in the workout, asset management and liquidation of commercial real estate. With creation of the special servicing function came the evolution of broad flexibility to modify, waive or amend the terms of mortgage loans. Early transactions allowed little servicer flexibility to work out delinquent loans, but major changes were made in later deals that provided much greater latitude. To ensure investor protection in

cases where loans were modified, the discounted mortgage loan (DML) concept was developed. The application of this concept meant that the present value of reduced cash flows resulting from loan modifications was drawn from the credit reserve fund as a pool value reduction and used to pay down certificate principal. Because of uncertainty regarding the quality of RTC commercial mortgage collateral, the market remained skeptical, even after the first few issues. Investors and other market constituents maintained a watchful eye on the performance of these transactions and demanded that more detailed information be made available. In response, the RTC, working with the servicers and rating agencies, created the Portfolio Performance Report (PPR) to provide investors and market constituents with updated, timely information regarding transaction performance. The PPR was generated monthly for each of the RTCs commercial mortgage transactions and provided detailed delinquency and loss information on the related mortgage pools. Delinquencies were sorted by loan group, by geographic concentration, and by property type. All loans 0 to 90+ days delinquent, foreclosures and REO properties were reported by number of loans and total dollar amount in multiple categories to describe the workout status.
(continued on p. 57)

WINTER 2005

53

54 CMBS WORLD

Canadian Corner (continued from p. 3)

triple-A across the board, which provoked an audience response from the rating agency to the majority view that all AAA bonds are not created equal. The final day started with a rousing panel who did not hold back their views on CMBS, which led to the topics of the dayA/B structures and whether subordination has become too high, too low or just right. We learned that CMBS are expanding globally, only the rating agencies can answer the question (sort of) to all you ever wanted to know about A/B structures and/or pari passu securitizations, and spreads are now too low or too high. Summing up, the conference was packed with good information, experienced and well-spoken panelists and some lively debates. The

conference ended with a well-attended and rightfully deserved break at the networking cocktail reception in the exhibit hall. Feedback from the attendees has been excellent, and we look forward to an even better event next year!

Pamela Spackman is President and CEO, Column Canada Financial Corporation; Chair of the CMSA Canadian Board of Governors and Co-Chair of the Canadian CMSA Conference. Kenneth Toten is Managing Director, Coventree Capital Group, Inc.; Vice Chair of the CMSA Canadian Board of Governors and Co-Chair of the Canadian CMSA Conference.

CMBS Collateral Performance (continued from p. 8)

QUARTERLY UPDATE
Loan Delinquencies

Lodging delinquencies fell by one third, continuing the pullback to 2001 levels. Retail delinquencies declined again. As the largest sector in the CMBS conduit market, improving retail delinquencies have been a significant driver of the overall decline in conduit delinquencies. Office delinquencies continued their recovery and are now lower than they were one year ago. Multi-family delinquencies remain above 1.5%. Relative performance versus the other major property types (OF and RT) deteriorated further. The multi-family delinquency rate is now 46% higher than office and 88% higher than retail. Industrial properties backed off somewhat, but remain the second highest, after lodging. Chart 7 uses dual scales because the relative level of lodging delinquencies is much higher than the other sectors. The most seasoned cohorts, 1996 through 2000, all shared in the improving delinquency picture. On a relative basis, the 2000 cohort continues to seriously underperform the cohorts which precede it. The 2001 cohort is now trailing the historical performance of the 1999 cohort, though still significantly ahead of the 2000 cohort. The 2002 cohort has now weakened relative to the 1998 and 1999 cohorts, and is performing on a par with those cohorts at the same point in their life cycles. The third quarter of 2004 shows a decline in the delinquency rate in every region of the country, some more dramatically than others. How does the relative performance of each region rank? One measurement of relative performance is the ratio of the delinquency rate in the 2004Q3 to the delinquency rate as of 2003Q4 (see Chart 6). Nationally, conduit delinquencies at the end of the third quarter were approximately 72% of the level at year end.

The East South Central region, while still the highest on an absolute basis, has been improving relative to the national average. The West South Central region is underperforming the rest of the country, on a relative basis. The Middle Atlantic Region, with the second lowest absolute delinquency rate, is underperforming the national average. The Pacific region is the strongest performer, on both an absolute and relative basis. Region East North Central East South Central Middle Atlantic Mountain New England Pacific Southern Atlantic West North Central West South Central
Non-Performing Loans

States IL, IN, MI, OH, WI AL, KY, MS, TN DC, DE, MD, NJ, NY, PA AZ, CO, ID, MT, NM, NV, UT, WY CT, MA, ME, NH, RI, VT AK, CA, HI, OR, WA FL, GA, NC, SC, VA, WV KS, IA, MN, MO, ND, NE, SD AR, LA, OK, TX

Non-performing lodging declined dramatically, with several high profile workouts being completed in the lodging sector. Multi-family non-performing loans declined somewhat, but still exceed the levels for the office and retail sectors. Retail non-performing loans declined, following the overall drop in delinquencies in this sector. Nonperforming loans are at the lowest level in over two years. Office non-performing loans declined again and are now comparable to levels of one year ago. Industrial properties had an increase in non-performing loans, reflecting the higher delinquencies in this category of the prior quarter.

Thomas A. Fink is a Managing Director at Trepp, L.L.C.

WINTER 2005 55

Conduit CMBS Balloon Risk in a Rising Rate Environment

(continued from p. 15)

CONCLUSION

It may be premature, but theory suggests the current cohort of low coupon loans will defease at higher rates than we have seen in the past if interest rates rise. In turn, this suggests that (1) the balloon risk in bonds backed by low coupon loans may be overstated, and (2) some bonds backed by pools of low coupon loans may outperform like-kind bonds backed by similar but higher coupon collateral. Such pools are not hard to identify. Prospectuses generally provide coupon stratifications, and CMBS data vendors routinely provide current and original coupon rate stratifications. The information is also usually available from dealers. There are, of course, multiple other factors to consider, but this one is certainly worth adding to the mix.

COMMERCIAL MORTGAGE SECURITIES ASSOCIATION

Peter Rubinstein, Ph.D., is a Managing Director and Head of CMBS Research at Bear, Stearns & Co. Inc. Alan Todd, CFA, is an Associate Director at Bear, Stearns & Co. Inc.
1

Occasionally, agency debentures are allowed in addition to Treasuries. This analysis ignores transaction costs required to defease. According to materials on Commercial Defeasance, LLCs website (www.defeasewithease.com), these are typically around $55,000 but can vary with loan size from around $40,000 up to $100,000. Most loans must be defeased to the original maturity date, but some are allowed to defease to the beginning of the open period, which could cause a few months of shortening. Over the course of ten years, however, this is not significant.

Borrower Guide to CMBS

MORTGAGE BANKERS ASSOCIATION

Lodging Revisited: Hospitality Sector is On the Mend

(continued from p. 48)

To order copies of this must have Guide, or to download a pdf from our website, go to www.cmbs.org or contact Shane Beeson, shane@cmbs.org.

We do expect that losses will continue to be higher among loans secured by hotels in markets with low barriers to entry and by older properties. The premium, brand-name properties, located in larger metro markets should continue to hold up for the next few years.

Kim Betancourt is a Senior Vice President at Realpoint and heads up the Senior Research Team. Peter P. Kozel, Ph.D., and Michael J. Magerman, CFA, are Senior Vice Presidents at Realpoint and members of the Senior Research Team.

56 CMBS WORLD

FDIC Closes the Books on RTC Securitization Program (continued from p. 53)

At the time of its inception, the PPR was the first attempt made by an issuer to provide monthly detailed performance information in a standardized format. This was a critical step forward in the development of an active secondary market for CMBS, which had been inhibited as a result of the lack of readily available information. The information first reported in the PPR reports served as a guide for the detailed information that is now routinely reported in statements to certificateholders for most commercial mortgage transactions. The combination of servicing innovations, improvement in transaction performance reporting, and continuous improvement in RTC/FDIC transaction oversight resulted in dramatic improvement in loss rates, resulting in increased recoveries to the FDIC on the credit reserve funds and the residuals. We believe these factors also contributed to cumulative loss rates decreasing progressively for successive issues. Charts 4 and 5 present initial reserve levels and cumulative loss rates by series for the CMBS and multi-family transactions.

amounted to 93.1% of the unpaid principal balance of loans sold, which was 13.4% higher than whole loan sales values. While pledged credit reserve funds averaged 26% of the collateral balance at issue, losses ultimately amounted to 7.8%. Beyond the monetary benefits to the government, the program was a major impetus to the development and expansion of the private CMBS market, which has grown from a $6 billion market in 1990 to a $350 billion market at the end of 2003. The scope of the program and successful transaction performance, in combination with major innovations in deal structure, servicing features and reporting, resulted in investor acceptance and the infrastructure necessary to support the long-term viability of CMBS in the capital markets.

George Alexander is a Manager in the Franchise and Asset Marketing Branch of the FDICs Division of Resolutions and Receiverships. Tom Raburn is a Partner with Raburn & Williamson, PLC.

CONCLUSION
The RTC securitization program was an unqualified financial success for the government. The discounted cash flows on the multi-family and commercial transactions

Save the Date

Eleventh Annual Convention June 8 - 10, 2005 NY Marriott Marquis, NYC

Details will be available soon on our website www.cmbs.org.

Sponsorship opportunities are available. For information, please contact Jane Marrinan at 212.589.0961 or jane.m@cmbs.org.

The Commercial Mortgage Securities Association (CMSA) is an international trade organization dedicated to improving the liquidity of commercial real estate debt securities through access to the capital markets.

WINTER 2005

57

O T

E B S I T E

I N K S

Commercial Mortgage Securities Association www.cmbs.org

TRUSTEES
The Bank of New York www.bankofny.com JPMorgan Chase www.morganmarkets.com LaSalle Bank N.A. www.etrustee.net Wells Fargo Bank, N.A. www.ctslink.com

SERVICERS

(cont.)

CRIIMI MAE Inc. www.criimimaeservices.com GEMSA Loan Services, L.P. www.gemsals.com GMAC Commercial Mortgage Corporation www.gmaccm.com Key Commercial Mortgage www.keybank.com Midland Loan Services, Inc. www.midlandls.com Ocwen Financial Corporation www.ocwen.com ORIX Capital Markets, LLC www.orixcm.com Pacific Life Insurance Company www.RealEstate.PacificLife.com Situs Servicing, Inc. www.situsos.com TriMont Real Estate Advisors www.trimontrea.com Wachovia Securities www.wachovia.com Wells Fargo Commercial Mortgage Services www.ctslink.com

RATING AGENCIES
Dominion Bond Rating Service Limited www.dbrs.com FitchRatings www.fitchratings.com Moodys Investors Service www.moodys.com Standard & Poors www.standardandpoors.com

SERVICERS
ARCap Servicing, Inc. www.arcap.com ARCS Commercial Mortgage www.arcscommercial.com BNY Asset Solutions, LLC www.bnyassetsolutions.com

The above websites are also available via links within the CMSA website: www.cmbs.org.

SUBMISSION OF MANUSCRIPTS FOR CONSIDERATION

Please refer to the following guidelines when submitting a manuscript to be considered for publication. The editors reserve the right to edit all articles for clarity and consistency. CMBS World assumes no responsibility for the loss or damage of unsolicited manuscripts or graphics.

1. Send three printed copies of the manuscript doublespaced with wide margins and pages numbered to: Jun Han, Editor-in-Chief John Hancock Real Estate Finance, Inc. 200 Clarendon Street, T56, Boston, MA 02117-0111 Phone: (617) 572-0820, Fax: (617) 572-3860 Email: jhan@jhancock.com 2. The front page should include the full name, company and title, address, telephone number, email, and brief bio of the author(s). If the paper is accepted for publication, the author will be asked to email the following to kcuffee@jhancock.com: (1) the paper in MS Word with exhibits in MS Excel, including source data file; and (2) a high resolution (300 dpi) photo in TIFF or EPS format. 3. References and endnotes should appear at the end of the text. Exhibits should be one to a page; each page clearly labeled with title of article. Number and title each exhibit (titles must be understandable without reference to the text) and write out all column headings and legends.

4. Limit references principally to works cited in the text and list them alphabetically. Citations in the text should appear as Johnson [1998] suggests that Include page numbers if applicable. 5. Minimize the number of endnotes. Use periods instead of commas between names of author(s) and titles of references. Use superscript Arabic numbers in the text and on the endnote page. 6. Center any equations on a separate line, numbered consecutively with Arabic numbers, in parentheses in the right margin. 7. CMBS World s copyright agreement form must be signed prior to publication. 8. Article submission deadlines: Spring 2005 issue December 29, 2004 Summer 2005 issue March 2, 2005 Fall 2005 issue June 29, 2005 Winter 2006 issue September 14, 2005
TM

58 CMBS WORLD

CMSA-Europe Hosts Its First Commercial Mortgage-Backed Securities Conference in Europe!

Save the Date

17 & 18 October, 2005 The Conrad Hilton, Brussels
Details will be available soon on our website www.cmbs.org
Sponsorship opportunities are available. For information, please contact Carol Wilkie at +44 (0) 20 7153 1276 or carol@cmbs.org

The Commercial Mortgage Securities Association (CMSA) is an international trade organisation dedicated to improving the liquidity of commercial real estate debt securities through access to the capital markets.

CMSA-Europe Hosts Its First Commercial Mortgage-Backed Securities Conference in Europe!

Save the Date

17 & 18 October, 2005 The Conrad Hilton, Brussels
Details will be available soon on our website www.cmbs.org
Sponsorship opportunities are available. For information, please contact Carol Wilkie at +44 (0) 20 7153 1276 or carol@cmbs.org

The Commercial Mortgage Securities Association (CMSA) is an international trade organisation dedicated to improving the liquidity of commercial real estate debt securities through access to the capital markets.