What are the major differences in structuring CMBS and RMBS transactions?

Question

What will be an ideal response?

Answer 1

The structure of a commercial mortgage-backed security or CMBS transaction is the same
(as in a nonagency residential mortgage-backed security or RMBS transaction) in that most structures have multiple bond classes (tranches) with different ratings, and there are rules for the distribution of interest and principal to the bond classes. However, there are three major differences due to the features of the underlying loans. These differences involve the prepayment terms, the role of the servicer when there is a default, and the role of the buyers when the structure is being created. More details are provided below.

First, as explained earlier, prepayment terms for commercial mortgages differ significantly from residential mortgages. The former impose prepayment penalties or restrictions on prepayments. Although there are residential mortgages with prepayment penalties, they are a small fraction of the market. In structuring a CMBS, there are rules for the allocation of any prepayment penalties among the bondholders. In addition, if there is a defeasance, the credit risk of a CMBS virtually disappears because it is then backed by U.S. Treasury securities. In fact, it is because investors like the defeasance feature for commercial mortgages used as collateral for a CMBS that defeasance has become the most popular type of prepayment protection.

The second difference in structuring is due to the significant difference between commercial and residential mortgages with respect to the role of the servicer when there is a default. In commercial mortgages, the loan can be transferred by the servicer to the special servicer when the borrower is in default, imminent default, or in violation of covenants. The key here is that it is transferred when there is an imminent default. The special servicer has the responsibility of modifying the loan terms in the case of an imminent default to reduce the likelihood of default. There is no equivalent feature for a residential mortgage in the case of an imminent default.

The particular choice of action that may be taken by the special servicer in a commercial mortgage will generally have different effects on the various bond classes on a CMBS structure. Moreover, there can be a default due to failure to make the balloon payment at the end of the loan term. There can be differences in loans as to how to deal with defaults due to a failure to meet the balloon payment. Thus, balloon risk must be taken into account in structuring a CMBS transaction, which because of the significant size of the payment, can have a considerable impact on the cash flow of the structure. Balloon risk is not something that has to be dealt with in structuring an RMBS.

The third difference in structuring between CMBS and RMBS has to do with the role of the buyers when the structure is being created. More specifically, typically potential buyers of the junior bond classes are first sought by the issuer before the deal is structured. The potential buyers first review the proposed pool of mortgage loans and in the review process may, depending on market demand for CMBS product, request the removal of some loans from the pool. This phase in the structuring process, which one does not find in RMBS transactions, provides an additional layer of security for the senior buyers, particularly because some of the buyers of the junior classes have tended to be knowledgeable real estate investors.