Fitch: Is CMBS 2.0 a Sign of Healthy Growth or Cause for Concern?

Concerns have begun to mount that underwriting standards for loans in newly issued commercial mortgage-backed securities (CMBS) are on the decline.
[IMAGE] Addressing this issue, the analysts at ""Fitch Ratings"":http://www.fitchratings.com say they believe there is ""quite a way to go"" before standards approach levels seen in 2007, a year viewed by many as the most volatile vintage for CMBS.

The New York-based ratings agency notes that some market participants fear we will shortly see loans comparable to the worst of the loans made between 2006 and 2008.

While Fitch agrees that underwriting standards have declined in recent months, the company's analysts stress that deterioration so far has been off of ""very high standards.""

""It was only a matter of time before CMBS underwriting standards began to decline from such an unusually high level,"" said Huxley Somerville, group managing director and head of U.S. CMBS for Fitch.

Fitch conducted a side-by-side comparison of key CMBS 2.0 transaction metrics with those from Fitch-rated CMBS 1.0 vintages, including 2007.

At the loan level, Fitch says debt service coverage ratio (DSCR) is the prime driver of default probability and loan-to-value (LTV) is a driver of both probability of default and probability of loss.

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The agency’s analysis shows that the metrics from 2010 and 2011 year-to-date are very similar to the metrics from 2003 and 2004, which are among the better performing vintages from a ratings standpoint. Both sets of metrics are “substantially more conservative” than the 2007 metrics, according to Fitch.

The agency says it anticipated a drop in underwriting standards in its ratings and has already raised credit enhancement levels for new CMBS to ensure ample credit risk protection.

Fitch released a commentary in June of last year predicting that the quality of CMBS deals would weaken over time because the first deals of CMBS 2.0 contained unusually low leverage.

The agency explained that greater confidence in the industry and greater competition among originators would make for more leverage.

Fitch went on to say that if its predictions were right, greater credit enhancement would be a result.

""If CMBS credit metrics begin to drop more precipitously, Fitch will raise credit enhancement levels accordingly,"" said Somerville.

Somerville said in the agency’s latest structured finance research commentary, “It has been said that commercial real estate operates on a 10-year cycle with seven-year memories. Therefore a more important question is, Where will underwriting standards be in two to three years?”

He added that the last thing the re-emergent CMBS industry needs is a return to 2007 in 2014, and dynamic that becomes especially relevant if loan originating shops continue to emerge and competition for loans increases.

“[T]here is little doubt that a large number of originators, chasing a finite supply of potential loans in any one year, will likely cause underwriting standards to drop further in order to win the mandate,” Somerville wrote. “It behooves all in the industry to ensure that discipline and memories are maintained so that the industry, too, is maintained.”