CRE Ch 20: Commercial Mortgage Backed Securities Flashcards
Describe key features of a CMBS
Commercial mortgage-backed securities (CMBS) are bonds backed by pools of
commercial mortgages
Provide claims to cashflows from the underlying mortgages as borrowers make
interest and principal payments
Securitization is the process of pooling the mortgages together, and selling new
classes of securities (called tranches) based on this pool
Each tranche is characterized by its priority of claim on the mortgage pool’s
cashflows
Bond rating agencies assign a credit rating to each tranche
Describe features of a senior tranche in a CMBS
The senior tranche 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
Any credit losses due to defaults from the mortgage pool are normally first
subtracted from the par value of the most junior tranche in a CMBS structure
Junior tranches have higher default risk than the loans in the mortgage pool, since
it provides credit support for the senior tranches
To compensate for this higher risk, junior tranches will be sold at a higher yield
(YTM) than the senior tranches
Define the subordination of a CMBS tranche
Subordination
Mortgage Pool Par Value - Tranche Par Value /
Mortgage Pool Par Value
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
CMBS payment structure where the most senior tranches are retired (i.e. receive their
principal) first before any subordinate tranches begin to receive principal payments
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?
Interest-Only Tranches are created from any extra interest left over from the underlying
mortgage pool after senior and junior tranches have received their coupon payments
Senior tranches typically offer a coupon rate that is lower than the WAC of the
mortgages in the pool
The remaining interest paid by the mortgages can then be ”stripped” off and sold
as a separate security
The claim to these interest payments are equal in seniority to that of Tranche A
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
Describe how bond rating agencies use the subordination of a CMBS tranche to
determine the tranche’s credit rating
Rating agencies determine how much subordination is required for a given credit rating
of a CMBS tranche
For example, rating agencies may require that all tranches rated AAA must have
at least 25% subordination, and all tranches rated AA must have at least 20%
subordination
The 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
Between 2001 and 2007, the CMBS-LIBOR spreads steadily decreased
However, after the 2008 financial crisis, the CMBS-LIBOR spreads drastically
spiked because of all the defaults from the underlying loans in the mortgage pools
Since the financial crisis, the CMBS-LIBOR spreads have slowly stabilized
Describe how moral hazard exists in a CMBS
Moral hazard is when one party controls an action that affects the risk of another party
In the CMBS industry, moral hazard exists 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
Describe how adverse selection exists in a CMBS
Adverse selection is when a relevant sample tends to have unfavorable characteristics
compared to the average characteristics in a population
This can occur if bond investors require higher yields from CMBS 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
