PRUDENTIAL FIXED INCOME High Quality CMBS: The Value of Structure Gary Horbacz, CFA Principal, Structured Product Research Team Prudential Fixed Income

July 2010

Commercial mortgage-backed securities (CMBS) are an important yet often misunderstood segment of the US fixed income market. Didn’t the commercial real estate bubble contribute to the 2007-2008 credit crisis? Aren’t these securities really risky? This paper provides a brief history of commercial mortgage-backed securities, explains in detail how they are structured, and shows why we believe certain types of commercial mortgage-backed securities can be especially attractive in fixed income portfolios today. The CMBS Market: Born From the Savings and Loan Crisis Before the 1980s, commercial real estate was financed almost exclusively by banks and insurance companies. Commercial real estate developers in need of a mortgage would apply for one, and after careful underwriting and due diligence, the bank or insurance company would issue the mortgage to the developer. The mortgage – a commercial real estate mortgage – would remain on the books of the bank or insurance company until it was paid off. This was good business at the time. In fact, commercial real estate lending was a prized revenue source for many banks in the late 1970s. The economic recession of the early 1990s changed all that, leading to a collapse in real estate prices and putting severe pressure on the existing commercial mortgage loans sitting on the books of the banks and insurance companies. This backlog of underwater mortgage loans, while certainly not the only reason, was one of the key factors that triggered the Savings and Loan (S&L) crisis. Following the crisis, banks and insurance companies sought to reduce the amount of commercial real estate loans on their books.

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As always seems to be the case, the eclipse of one source of funds invariably led to the birth of another. And so from the S&L crisis emerged a new source of financing for commercial real estate activity: the commercial mortgage-backed securities market. A mortgage lender could now assemble a pool of the commercial mortgage-backed loans it had made and sell the entire package of loans to an intermediary, typically a trust or a special purpose vehicle (SPV). That entity, in turn, would “securitize” them. To do so, the SPV would divide up the pool of mortgage loans it had purchased into a range of different “buckets” based on perceived credit risk, maturity, and other characteristics, and would then issue different securities for each risk tier.

The Importance of the CMBS Securitization Process This securitization process for the CMBS market, like the process for other structured product markets, served three important purposes: 1) Provided a continuing stream of new capital to mortgage lenders. By removing the existing mortgage loans from the books of lenders, it provided lenders with fresh capital to make new commercial mortgage loans, stimulating the US economy. 2) Provided more investors with a new source of potential return. Formerly, only investors with significant commercial real estate expertise were able to reasonably invest in commercial mortgage loans. Securitization helped to bring commercial real estate finance into the “mainstream”, broadening the sector’s appeal to a wider range of investors and increasing liquidity in the sector dramatically. 3) Provided investors a new-found way to finely structure their risk. Because the securitization process effectively placed the resulting commercial mortgage-backed securities into different “risk tiers”, it permitted investors to purchase only the type and degree of risk they explicitly wanted to assume. The efficiency with which the commercial real estate securitization market matched different investor appetites with desired types of securities led to rapid growth soon after its birth. As Figure 1 below illustrates, issuance of commercial mortgage-backed securities rose rapidly beginning in the late 1990s, reaching a record-high in 2007: Figure 1 Commercial Mortgage-Backed Security Issuance 1990-2009 $ billions 250 200

CMBS Annual Volume

150 100 50 0

Source: Commercial Mortgage Alert. US issuance only. As of December 31, 2009.

Securitization Brought Change to the Commercial Mortgage Loan Market The securitization process dramatically improved both liquidity and transparency in the commercial mortgage loan market, both long-awaited and welcome developments. It also increased the demand for new commercial mortgage loans to use as collateral for the securitizations. Many lenders, some of them newer entrants into the commercial lending business, were eager to provide the required supply. Originating a commercial mortgage loan and then selling it to a CMBS trust was a profitable venture for Wall Street and, unlike the traditional commercial mortgage loans banks and insurance companies had been making, this new business required no retention of risk on their part. Indeed, this dynamic caused a fundamental shift in the commercial mortgage market: the CMBS securitization process meant that many new commercial mortgage loans were now being originated solely for the purpose of securitization. In 2007, CMBS represented almost 45% of new commercial mortgage origination. Securitized lenders began competing aggressively to make new commercial mortgage loans, and, not surprisingly, underwriting standards began to deteriorate. Two key indicators of declining loan quality are seen in Figure 2 on the left, below. The first is Debt Service Coverage Ratio, or DSCR, which is defined as a property’s income divided by its debt service. Debt-service coverage ratios describe the amount of the property’s cash flow that is available to meet interest and principal payments on the loan. Lower DSCRs indicate riskier loans.


The Loan-to-Value (LTV) ratio is the second key indicator of loan quality. The LTV ratio expresses the size of the mortgage loan as a percentage of the value of the underlying property held as collateral. It is critically important to valuing the underlying collateral within a CMBS trust. At time of issuance, loans in a typical CMBS trust may have an average LTV ratio of 75% 1, with the ratios of individual loans ranging from 50% to perhaps 80%. Note that Figure 2 below shows changes over time in Moody's “stressed” DSCRs and LTVs. Moody's computes stressed DSCR using a constant loan coupon for all loans, thus putting the DSCR for loans originated under different interest rate environments on an "apples-to-apples" basis. Likewise, Moody's assumes a constant relationship between property value and property income when computing stressed LTVs. Moody's normalization of DSCR and LTV permits easier identification of trends in the quality of loan underwriting across different time periods by removing the effects of both the interest rate environment and the required returns that happened to be in effect when a particular loan was originated. When these are removed, trends that otherwise might not be apparent can be identified. As shown in Figure 2, Moody's stressed DSCR fell precipitously from 2003 through 2007, while Moody's LTV rose nearly 25% over the same period. These trends reflected two dynamics: rapidly rising commercial real estate values relative to property income and more aggressive initial underwriting for new loans. Indeed, Figure 3 below shows the sharp rise in riskier “interest only” loans2 during this time. Figure 2 Loan Underwriting Standards Declined Rapidly Beginning in 2005 Credit Trends of U.S. Conduit Securitizations 3Q2002 – 2Q2008

Moody’s LTV (RHS)

Moody’s DSCR (LHS) 1.25 1.20 1.15 1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75

Figure 3 Sharp Rise in “Interest-Only” Loans As Underwriting Standards Deteriorated 2000-2007

Mdy's DSCR Moody’s DSCR Moody’s LTV Mdy's LTV

Loans Requiring Both Interest and Principal Payments Loans Permitting Some Periods of Interest-Only Payments 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

120% 110% 100% 90% 80% 70% 60%

Source: Moody’s. As of March 31, 2008.

Source of data:

These are “conduit securitizations”, comprised of diverse pools of underlying commercial mortgage loans. They are the most common type of CMBS.


An average LTV ratio of 75% means that, on average, the outstanding balances on the mortgage loans equal 75% of the value of the commercial properties within the trust: $75 million of loans on properties worth $100 million, for example.


These loans, as their name suggests, required only interest payments during the term of the loan, with a balloon payment at maturity.


Like All Bubbles, This One Also Burst The development and growth of the securitization process created demand for new commercial mortgage loans, and this demand, in turn, put upward pressure on commercial real estate prices. By mid-2007, though, the bubble was showing signs of fatigue. As Figure 4 below shows, sales of commercial properties reached a lofty $70+ billion in the second quarter of 2007, but then began tumbling from there. From their peak in mid-2007 to trough early this year, sales of commercial properties fell a stunning 89%. With sales plunging, prices of commercial real estate properties followed suit, falling 44%, as seen in Figure 5 below: Figure 5 Sharp Drop-off in Prices of Commercial Properties Beginning in Mid-2007

Figure 4 Sharp Drop-off in Sales of Commercial Properties Beginning in Mid-2007

$ billions 80 Industrial 70 Apartment 60 50 40 30 20 10 0

Retail Office

Index Value 200 180

Peak to 1Q10: -89%

Commercial Property Price Index

160 Δ-44%

140 120

One Year: -23%

100 80

Source: Reis; US domestic arms-length transactions of $2 million and greater. Used with permission.

Source: Moody’s/REAL Commercial Property Price Indices, May 2010.

Not surprisingly, commercial mortgage loan delinquencies soared in response, from a low of 0.4% in early 2007 to a current high of 8.9%. Figure 6 CMBS Loan Delinquencies as % of CMBS Loans Outstanding Fixed Rate CMBS Conduit Securitizations April 2002 - June 2010 % 10 9 8 7 6 5 4 3 2 1 0

Delinquent Loans



Source: RBS, Barclays Capital, and Trepp. As of June 2010.


The Impact on the CMBS Market With such turmoil throughout the commercial real estate market, it is not surprising that spreads of commercial mortgage-backed securities ratcheted wider in response. The spreads of high quality, AAA-rated commercial mortgage-backed securities hit a peak of swaps +1500 bps during the depths of the global credit crisis in November 2008. As it did with other sectors of the credit markets, the US Government intervened in early 2009 to try and stop the decline of the commercial mortgage-backed securities market. Government-initiated programs such as the Term Asset-Backed Securities Loan Facility (TALF) and the Public-Private Investment Program (PPIP) were designed to improve liquidity and promote price transparency in the securitization markets and furnish new capital. These efforts, along with an improving economic picture, helped spreads on commercial mortgage-backed securities tighten substantially throughout 2009 and so far in 2010. Despite this significant recovery, spreads on AAA-rated commercial mortgage backed securities are still wide relative to investment grade corporate bonds and other securities: Figure 7 CMBS Spreads Ratcheted Wider During Crisis and Then Rebounded Sharply, But Remain at Attractive Levels January 2007 - July 2010 Spread to LIBOR 1800 1600 1400 1200 1000 800 600 400 200 0

10 Yr Super Senior CMBS Invest Grade Corp

375 bps 180 bps

Source: JPMorgan and Barclays Capital. As of July 21, 2010.

These relatively generous spreads, coupled with the unique structural characteristics of commercial mortgagebacked securities, make certain tranches of these securities highly attractive today. To understand why, let’s first understand the structures and features of such securitizations.

The Basic Features of a Commercial Mortgage-Backed Security Commercial mortgage-backed securities are bonds backed by commercial mortgage loans. Loans on all commercial property types are eligible as collateral, including loans for multi-unit apartment buildings, office complexes, malls and other retail structures, industrial units such as bulk distribution and warehouse facilities, hotels, healthcare facilities, and manufactured housing. Most geographic locations across the US are represented. Collateral sizes range from small $1 million loans for a single property to massive multi-billion-dollar loans for large-scale retail and office developments. The loans are generally structured with final maturities of five, seven, or 10 years, with most loans having terms of 10 years. Commercial mortgage loans almost always have a large balloon payment due at final maturity.


Once commercial mortgage loans are made, the mortgage originator groups the loans together into pools. Pools generally contain between 100-300 loans, but pool characteristics can vary widely. “Conduit securitizations” are loan pools that are typically diversified across loan size, with the ten largest loans comprising perhaps 30-40% of the pool. Conduit deals are geographically diversified, but do tend to have higher exposure to the major economic producing regions of the country (i.e., northern and southern California, Texas, and New York). The office, retail, and multifamily property types typically represent 60-80% of each transaction, with the mix of each type varying substantially from deal to deal and across vintages. The mix often depends upon the amount of new construction of each property type along with the number of sales of existing properties. The mortgage originator sells the pools to a Special Purpose Vehicle that will securitize them. A Special Purpose Vehicle, or SPV, is a legal entity set up by a company, typically an investment bank or other financial institution, for a specific purpose of issuing commercial mortgage-backed securities. There are five key features of commercial mortgage-backed securitizations that are critical to understanding how they work: 1) Multiple Tranches A defining feature of all commercial mortgage-backed securitizations is that they are issued in different “tranches”, with each tranche differing in payment priority, duration, and yield. The SPV hires an external rating agency to assign credit ratings to each tranche. Figure 8 below illustrates the tranche structure. As you can see, tranches range from AAA-rated all the way down to unrated. Over the years, tranches have become highly segmented, with a number of variations even within a given ratings tier. By 2005, while the rating agencies had become comfortable assigning AAA ratings to tranches with only 12-15% credit enhancement, many investors in the CMBS market were not as enthusiastic. These investors began demanding tranches with higher levels of credit enhancement. The CMBS market evolved accordingly, to a practice of creating three basic classes of AAA-rated tranches within a commercial mortgagebacked securitization: “super senior” AAA tranches, a “Mezzanine” AAA tranche, often referred to as the “AM” tranche, and a “Junior” AAA tranche, or “AJ” tranche. Each tranche carried a different risk and reward profile because of its degree of credit enhancement and placement in payment priority within the overall securitization. 2) Varying Degrees of Credit Enhancement SPVs issuing CMBS often provide “credit enhancement” to certain tranches of the securitization to improve their credit quality and earn a higher rating from the external ratings agencies. The securitization illustrated in Figure 8 below includes: a) A “Super Senior” AAA tranche as its highest and most creditworthy tranche. Super-senior tranches often came with 30% credit enhancement, meaning that the tranches subordinate to it comprise 30% of the securitization. The subordinated 30% is the first to absorb any losses that might occur from the underlying loans. b) Immediately below that, but still rated AAA at origination, was often a “Mezzanine” AAA tranche (also referred to sometimes as the “AM” tranche). This tranche typically offers 20% credit enhancement, meaning that 20% of the securitization is subordinated to this tranche and thus absorbs any losses that might occur among the loans. c) Below that, but again still rated AAA at origination, was often a “Junior” AAA tranche (also referred to as the “AJ” tranche) with 12-15% credit enhancement.


3) A “Waterfall” Payment Structure Another defining feature of commercial mortgage-backed securities is their sequential payment structure, also known as the “waterfall”. The waterfall structure determines how payments are made and losses absorbed within a securitization. To best understand the waterfall structure, let’s first review what happens when a commercial mortgage loan defaults. After a default, the commercial property is foreclosed on by the servicer and typically sold. The net proceeds from the foreclosure sale become the recovery proceeds of the loan. For example, if the remaining loan balance was $1 million, and the foreclosed property sale netted $600,000, the trust would recognize a “principal recovery” of $600,000 and a “realized loss” of $400,000. Said differently, the trust incurred a “loss severity” of 40% and a “recovery rate” of 60%. Now let’s see how this is applied to a commercial mortgage-backed securitization. Under the waterfall structure illustrated below, if any of the underlying mortgage loans default and the recovery proceeds fall short of the outstanding loan amount, the resulting realized losses are applied sequentially, in reverse order, starting at the bottom and moving up. The unrated subordinate tranche is the first to absorb the loss, until that tranche is completely written down. Losses then accrue upward to the B tranche, until it is completely written down, then to the BB tranche, and so forth. The key point is that no super senior tranche can take even $1 of principal loss until all subordinated tranches have been completely written down to zero. This would require realized losses in excess of 30% of the outstanding loans. The same process is applied, in reverse, for principal payments, including scheduled principal and loan prepayments as well as, importantly, recoveries on defaulted loans. All principal payments received each month are paid out to each tranche sequentially, starting from the top and moving down. Investors in the “super-senior AAA” tranche are paid first until each investor is fully paid, then the mezzanine AAA class is paid, then the junior AAA tranche is paid, and so on through the other subordinated tranches until all payments are exhausted. Figure 8 Typical Commercial Mortgage-Backed Security Structure Super Senior AAA


AAA Mezzanine

10.125% $2.5 Billion Mortgage Pool

7.750% 4.500% 3.000%

Subordinated Tranches


2.125% 1.375%

Principal Paid From Top Down



Losses Accrued From Bottom Up



Source: JPMorgan. An Introduction to CMBS April 2008

= Default x (1 – Loss Severity Rate) = Principal Recovery = Default x Loss Severity Rate = Principal Loss


4) Super-Senior Tranche Divided Further Into Time Tranches The two remaining features of commercial mortgage-backed securitizations are perhaps the most interesting, in that they provide investors a unique ability to identify and select precise risk exposures: time tranches and tranche “thickness”. When an SPV creates a commercial mortgage-backed securitization, it can assemble the tranches in any number of ways. How the tranches are assembled – how many there are and how large each tranche is -- depends on the characteristics of the underlying collateral as well as investor preference and demand. We saw in Figure 8 that most commercial mortgage-backed securitizations have a number of different AAA-rated tranches. In fact, most commercial mortgage-backed securitizations then further segment the highest “super senior” tranche. As illustrated in Figure 9 below, most “super-senior” tranches are further sub-divided into “time” tranches, typically named “A1” through “A4”: Figure 9 Typical Commercial Mortgage-Backed Security Structure “Super-Senior” Top Tranche Further Segmented By Time Tranches Principal Super Senior AAA





AAA Mezzanine AAA Junior AA A BBB BB B Unrated Source: JPMorgan. An Introduction to CMBS, April 2008.

The original size of the A1–A4 time tranches are determined by the maturity schedule of the underlying loans in the securitization. Generally, the A1 tranches are sized to reflect scheduled principal payments expected to occur within three years. A2 tranches are sized to reflect scheduled principal payments expected to occur between three and five years, A3 tranches are sized to reflect payments between five and seven years, and A4 tranches reflect payments in eight or more years. We consider the A1 through A3 tranches as “intermediate” tranches and the A4 tranche as the “last cash flow” tranche. Early time tranches are paid principal fully before any principal payments are made to the later time tranches. In other words, all investors in the A1 tranche are paid fully before any investor in the A2 tranche is paid at all. In this way, time tranches redistribute risk even more finely within the AAA-rated super-senior class of a securitization. This notion of time tranches dramatically changes the risk-reward dynamic of investing in commercial mortgage-backed securities for many investors. Indeed, it even permits investors with pessimistic outlooks on commercial real estate to invest in the sector. It is important to understand that this sequential payment priority among super-senior tranches will hold as long as realized losses on the underlying loans do not exceed the 30% super-senior credit enhancement. However, if realized losses ever exceed this level, then all future principal payments from that point


forward will be shared pro-rata between all remaining super-senior tranches. The importance of this concept, referred to as the “pro-rata trigger”, will become even clearer after we understand “tranche thickness”. 5) Tranche “Thickness” Each of the individual super-senior time tranches of a securitization could represent anywhere from 1% to 70% of the entire securitization. This concept is known as “tranche thickness” and refers to the percentage of the total securitization that a given tranche comprises. In Table 1 below, we show two different hypothetical securitizations: one with “thin” intermediate super-senior tranches and the other with “thick” intermediate supersenior tranches. “Cumulative thickness” refers to the size not only of a given tranche, but also includes all tranches that come before it in payment priority. Because payments in a commercial mortgage-backed securitization accrue sequentially, the cumulative thickness of your tranche in a securitization is an important determinant of whether you will receive your full principal payments in a stress scenario. There are important differences between cumulatively thin and cumulatively thick tranches. A “cumulatively thin” tranche requires fewer principal payments or recoveries to be fully repaid, while a “cumulatively thick” tranche requires more principal payments. In Deal A in the example below, the A3 tranche is cumulatively thin, comprising only 13% of the overall securitization. The A3 tranche in Deal B, on the other hand, comprises 43% of the securitization, and is thus considered a “cumulatively thick” tranche. In Deal A, only 13% of the loans within the entire deal must repay in order for all investors in the tranche to be repaid fully. In Deal B, on the other hand, fully 43% of the loans within the entire deal must repay for investors in the A3 tranche to be repaid fully. For this reason, cumulatively thick tranches are not always the most desirable. In fact, the reverse is often true: the thinner the tranche, the more defensive the security. Thin tranches require less principal repayment, either from scheduled payments or recoveries on defaulted loans. The lower overall principal required to be repaid shortens the timeframe needed for payment and lowers the likelihood of hitting the pro rata trigger prior to tranche repayment. Table 1 Investors Are Repaid Differently Depending on Whether a Tranche is “Thick” or “Thin” Class A1 A2 A3 A4 Subordinate

Deal A: Thin Tranches Thickness Cumulative Thickness 3% 3% 7% 10% 3% 13% 57% 70% 30% 100%

Deal B: Thick Tranches Thickness Cumulative Thickness 3% 3% 20% 23% 20% 43% 27% 70% 30% 100%

Source: Prudential Fixed Income. For illustrative purposes only.

How These Features Combine to Provide Protection to a CMBS Investor Let’s now look at an example that illustrates how all of these features within a securitization can provide fixed income investors with a unique risk and reward opportunity. Table 2 below illustrates a hypothetical securitization that includes $100 million of commercial mortgage loans. The SPV has structured this particular securitization to include many different tranches, each a different size and with a different degree of credit enhancement. The $70 million AAA-rated super-senior tranche is further subdivided into four different time tranches.


Table 2 Hypothetical $100 Million CMBS Securitization With The Super-Senior AAA-Rated Tranche Further Divided Into Four Time Tranches Tranche Name

Super Senior AAA $70 mm Mezzanine AAA Junior AAA Other Subordinated

SubDivision Tranches A1 A2 A3 A4 Total AM AJ B - NR

Tranche Size ($mm) $3 $7 $3 $57 $70 $10 $8 $12

Tranche Credit Enhancement 30%3 30%3 30%3 30%3 30% 20%4 12%4 0%4

Tranche Tranche Thickness1 Cumulative Thickness2 3% 3% 7% 10% 3% 13% 57% 70% 70% 70% 10% 80% 8% 88% 12% 100%

Scenario Principal Loss 0% 0% 0% 70% 100% 100% 100% 100%

Source: Prudential Fixed Income. For illustrative purposes only. 1 Tranche Thickness = tranche size/total deal size. 2 Tranche Cumulative Thickness = tranche thickness + thickness of all tranches paid before such tranche. 3 Tranche Credit Enhancement for super-senior AAA = 30%. 4 Tranche Credit Enhancement for other tranches = 100% - cumulative thickness; represents the amount of realized loss on the underlying loans as a percentage of the total pool that can be experienced before such class will take a loss.

Now let’s assume a draconian scenario in which 100% of the loans default with a 70% loss severity. A 70% loss severity means that the pool will suffer $70 million of losses and have $30 million of principal recoveries. Understand that these assumptions are extremely pessimistic. To put them in perspective, the worst cumulative commercial mortgage loan default rate ever experienced by any vintage was approximately 30%. Historical loss severities have averaged 30%. The combination of a 30% default rate and a 30% loss severity produces realized losses of 9%. The scenario we will discuss below produces 70% realized losses. The last column in Table 2 above illustrates that even under these very extreme assumptions, the A1, A2, and A3 time tranches experience no loss. This seems counterintuitive, since the trust experienced 70% losses and these tranches had only 30% subordination. The key is the recovery value of the defaulted loans. Although the trust had 70% losses, it also had a 30% recovery rate on the defaulted loans. As the losses were applied to the subordinate tranches, recovery proceeds were being paid to the super-senior tranches sequentially. In the example above, recovery proceeds equaling 13% of the pool are received prior to the securitization reaching 30% realized losses.1 Since the cumulative thickness of the A3 tranche is only 13%, the A3 tranche and the ones in front of it (A1 and A2) are paid out in full before the losses pierce the 30% pro-rata trigger. The last cash flow A4 tranche is left to absorb the remaining principal losses by itself: in our draconian scenario above, that tranche would incur a 70% loss. This example demonstrates that if cumulative principal payments (scheduled principal payments as well as recoveries from defaulted loans) as a percentage of the total pool meets or exceeds a particular tranche’s cumulative thickness before realized losses exceed 30%, then that tranche will be repaid in full. Cumulatively thin tranches in a securitization are highly likely to pay in full. That’s because even if defaults were high enough to incur 30%+ realized losses in the overall securitization, thereby breaching the trigger level, those defaults would generate at least some recoveries as they occur. These would be applied sequentially, starting with the first time tranche. For this reason, time tranches in CMBS securitizations that are cumulatively thin can withstand extreme realized loss scenarios in the underlying pool.


Since a constant 70% loss severity is assumed for all loans, the 30% pro rata trigger is hit after 43% of the underlying loans default (70% loss severity x 43% defaulting loans = 30% loss). Since a 70% loss severity translates into a 30% recovery rate (recovery rate = 1 - loss severity), then the same 43% defaulting loans produce 13% of recovery proceeds (30% recovery rate x 43% defaulting loans = 13% of recovery proceeds).


Our View On the CMBS Market Today At Prudential Fixed Income, we are quite positive on the defensive segments of the CMBS market. Our preferences for individual securities are based upon our views of the quality of underwriting and the level of commercial real estate prices at the time when the particular CMBS securitization was issued. Currently, our favorite securities are: Thin Intermediate Super Senior Tranches of Securitizations Issued Between 2006 and 2008 Given the top-of-the-market commercial real estate prices between 2006 and 2008, along with the very aggressive underwriting practices that characterized loans originated during these "bubble years", we favor the most defensive securities in these vintages. Cumulatively thin intermediate (A2-A3) super senior time tranches provide substantial protection against a tail scenario, yet currently offer very attractive spread levels of swaps + 250 bps. (As of July 22, 2010). While the last cash flow A4 tranches from these weaker securitizations offer even wider spreads of approximately +350 bps, we believe they have a meaningful chance of loss in a stress scenario. In our view, the extra +100 bps of spread does not compensate for this additional risk. It should be noted that, given today’s low rate environment, these securities are currently trading at premium prices. ($101- $104 as of July 22, 2010.) This exposes these securities to a different risk: early repayment risk. In a severe stress scenario, these premium-priced securities could repay at par sooner than anticipated, detracting from total return. We rely on extensive loan level analysis to help mitigate this risk. Last Cash Flow Tranches From Older Securitizations Issued Prior to the Second Half of 2006 We have a more positive expectation of loan performance for most securitizations issued prior to the second half 2006, given the more conservative underwriting practices and the lower commercial real estate prices at the time of underwriting. For these older securitizations, we prefer the last cash flow super senior time tranche (A4). These currently offer spreads over swaps of +165 bps for 2005 securitizations and +200 bps for early 2006 securitizations. Have Not Yet Purchased Newer Securitizations Issued in 2009-2010 As noted earlier, the CMBS market is slowly recovering, with six new securitizations issued during the last quarter of 2009 and so far into 2010. This new issuance can be characterized by generally fewer loans in each deal and more stringent underwriting of each loan. Loan-to-value ratios are lower (healthier), with current LTVs of 50-65% based upon today's property valuations, rather than 70-75% LTVs based upon what were peak market commercial real estate prices back in 2007. Debt-service coverage ratios in the newer securitizations are based on actual in-place (realized) cash flows rather than the pro-forma cash flows used at the peak of the market. Despite these attractive attributes from a loan-level credit standpoint, we are currently not buying these new CMBS securitizations. While the quality of the underlying loans has significantly improved, these securitizations have less credit enhancement and less loan diversification. Furthermore, the AAA-rated last cash flow tranches from these securitizations are currently offered at lower spreads of +150 bps over swaps. (As of July 22, 2010.) We believe this spread concession to more seasoned deals is unwarranted, particularly given the structural protections we can find in thin intermediate tranches of 2006-2008 securitizations or in last cash flow super senior time tranches of 2005 securitizations.


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