CRE 20 - Commercial Mortgage Backed Securities

Question 1

Describe key features of a CMBS and securitization

Answer 1

Bonds backed by pools of commercial mortgages that provide claims to cashflows from underlying mortgages as borrowers make interest and principal payments

Question 2

Describe Securitization in CMBS

Answer 2

• 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

Question 3

Benefits of CMBS market toward commercial real estate

Answer 3

Improve liquidity and transparency

Question 4

Benefit of unbundling of mortgage credit risk

Answer 4

Creates different securities that better match the needs of specific investor groups, thus creating value

Question 5

Describe features of a senior tranche in a CMBS

Answer 5

• Receives the highest priority from mortgage payments
• Only faces credit losses after the par value of the more junior tranches is
  completely wiped out

Question 6

Describe features of a junior tranche in a CMBS

Answer 6

• 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

Question 7

Define the subordination of a CMBS tranche

Answer 7

• 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

Question 8

Formula for the subordination of a CMBS tranche

Answer 8

Question 9

How does the subordination level of a senior tranche change as loans mature in a CMBS mortgage pool?

Answer 9

As more loans in the underlying pool pay off principal over time, the amount of
subordination in a senior tranche will increase

Question 10

Describe a waterfall payment structure in a CMBS

Answer 10

Most senior tranche is retired before any subordinate tranches begin to receive principal payments

Question 11

Describe a first-loss tranche in a CMBS structure

Answer 11

Absorbs any credit losses due to defaults in any of the
mortgages in the pool are first

Question 12

Compare and contrast the interest rate risk of senior and junior CMBS tranches

Answer 12

• 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

Question 13

How is an Interest-Only Tranche created?

Answer 13

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

Question 14

Coupon Rate of Senior tranches in CMBS Structure

Answer 14

• 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

Question 15

Claim to interest payments of Interest-Only Tanches in a CMBS Structure

Answer 15

equal in seniority to that of senior tranches

Question 16

List different sources of value that CMBS provides to investors

Answer 16

• 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

Question 17

The basic principle of mortgage securitization (CMBS)

Answer 17

the value of the tranches sold to investors must be greater than the par value of the mortgage pool underlying the securites

Question 18

Describe how bond rating agencies use the subordination of a CMBS tranche

Answer 18

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

Question 19

Describe how CMBS-LIBOR spreads have changed from the 2000 to the present day

Answer 19

• 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,

Question 20

Emergence of “super-senior” tranches in CMBS around 2004

Answer 20

• 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

Question 21

What did low CMBS-LIBOR spreads in early 2000s signal?

Answer 21

Signaled that bond market investors overlooked the default risk in CMBS

Question 22

Tranches and Subordination of CMBS today

Answer 22

fewer tranches and higher subordination

Question 23

Describe how moral hazard exists in a CMBS

Answer 23

• 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

Question 24

Definition of Moral Hazard

Answer 24

Moral hazard is when one party controls an action that affects the risk of another party

Question 25

Definition of Adverse Selection

Answer 25

When a relevant sample tends to have unfavorable characteristics compared to the average characteristics in a population

Question 26

Describe how adverse selection exists in a CMBS

Answer 26

• 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

Question 27

How can Moral hazard and adverse selection compound each other’s effects on the CMBS industry?

Answer 27

• 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