CRE 20 - Commercial Mortgage Backed Securities Flashcards
Describe key features of a CMBS and securitization
Bonds backed by pools of commercial mortgages that provide claims to cashflows from underlying mortgages as borrowers make interest and principal payments
Describe Securitization in CMBS
- Process of pooling the mortgages together, and selling new classes of securities (called tranches) based on this pool
- Securitization redistributes risk to different investors
- Each tranche is characterized by its priority of claim on the mortgage pool’s cashflows
- Bond rating agency assign a credit rating to each tranche
Benefits of CMBS market toward commercial real estate
Improve liquidity and transparency
Benefit of unbundling of mortgage credit risk
Creates different securities that better match the needs of specific investor groups, thus creating value
Describe features of a senior tranche in a CMBS
- Receives the highest priority from mortgage payments
- Only faces credit losses after the par value of the more junior tranches is
completely wiped out
Describe features of a junior tranche in a CMBS
- Absorbs any credit losses due to defaults from the mortgage pool
- Have higher default risk than the loans in the mortgage pool, since it provides credit support for the senior tranches
- Sold at a higher yield (YTM) than the senior tranches, to compensate for the higher credit risk
- Under a sequential-pay waterfall structure, junior tranche also has the highest interest rate risk because its par value will be retired last
Define the subordination of a CMBS tranche
- Percentage of total losses that need to occur in the loan pool before the tranche suffers any losses
- Higher subordination = less default risk in a tranche
Formula for the subordination of a CMBS tranche
How does the subordination level of a senior tranche change as loans mature in a CMBS mortgage pool?
As more loans in the underlying pool pay off principal over time, the amount of
subordination in a senior tranche will increase
Describe a waterfall payment structure in a CMBS
Most senior tranche is retired before any subordinate tranches begin to receive principal payments
Describe a first-loss tranche in a CMBS structure
Absorbs any credit losses due to defaults in any of the
mortgages in the pool are first
Compare and contrast the interest rate risk of senior and junior CMBS tranches
- Senior tranches have a shorter weighted average maturity (WAM) and lower interest rate risk, since their par value will get retired first
- Junior tranches have a longer WAM and higher interest rate risk
How is an Interest-Only Tranche created?
Created from any extra interest left over or stripped off from the underlying mortgage pool after senior and junior tranches have received their coupon payments
Coupon Rate of Senior tranches in CMBS Structure
- Coupon rate that is lower than the WAC of the mortgages in the pool
- Due to higher credit quality than the mortgages in the CMBS pool
- Senior tranches normally sold at par
Claim to interest payments of Interest-Only Tanches in a CMBS Structure
equal in seniority to that of senior tranches
List different sources of value that CMBS provides to investors
- Tranches cover a range of risks that match the needs of different investors
- Allows passive investors with no real estate expertise to invest in senior CMBS tranches
- Can rely on bond ratings of tranches to assess risk
- Increased liquidity compared to the underlying loans inside the mortgage pool
- Efficiency gains and cost reduction
The basic principle of mortgage securitization (CMBS)
the value of the tranches sold to investors must be greater than the par value of the mortgage pool underlying the securites
Describe how bond rating agencies use the subordination of a CMBS tranche
Rating agencies determine how much subordination is required for a given credit rating of a CMBS tranche
- credit rating a tranche receives largely determines its yield-to-maturity
Describe how CMBS-LIBOR spreads have changed from the 2000 to the present day
- Steadily decreased b/w 2001 and 2007
- drastically spiked after the 2008 financial crisis, due to all the defaults from the underlying loans in the mortgage pools
- slowly stabilized since the financial crisis,
Emergence of “super-senior” tranches in CMBS around 2004
- Tranches that had even more subordination than what the credit rating agencies were willing to give the top rating, AAA, to
- Indicated that conservative bond investors believed that subordination levels the rating agencies were requiring for high-rated bonds were too low
What did low CMBS-LIBOR spreads in early 2000s signal?
Signaled that bond market investors overlooked the default risk in CMBS
Tranches and Subordination of CMBS today
fewer tranches and higher subordination
Describe how moral hazard exists in a CMBS
- when issuers give loans to high-risk individuals, but then immediately pass on the risk to other parties by selling the loans into a CMBS pool
- After selling the loans, the issuer is no longer subject to the risk it created
Definition of Moral Hazard
Moral hazard is when one party controls an action that affects the risk of another party
Definition of Adverse Selection
When a relevant sample tends to have unfavorable characteristics compared to the average characteristics in a population
Describe how adverse selection exists in a CMBS
- Can occur if bond investors require higher yields from CMBS lenders because they are viewed as more risky
- This causes lower risk individuals to borrow from non-CMBS lenders to get lower interest rates
- As a result, the group of borrowers in the CMBS industry will have higher credit risk than the general population
How can Moral hazard and adverse selection compound each other’s effects on the CMBS industry?
- bond market investors’ awareness of moral hazard can cause them to require higher yields in CMBS bonds to compensate for this risk
- These higher yields will force the CMBS conduit loan originators into an adverse selection situation where the main borrowers in the CMBS pool have poor credit quality
- higher credit risk will give more incentives for the loan issuers to sell off the loans quickly and pass the risk to other parties, thus worsening this moral hazard / adverse selection feedback loop
