How does the analysis of a commercial mortgage-backed security differ from that of a residential mortgage-backed security?

Question

What will be an ideal response?

Answer 1

A commercial mortgage loan is originated either to finance a commercial purchase or to refinance a prior mortgage obligation. Unlike residential mortgage loans where the lender relies on the ability of the borrower to repay and has recourse to the borrower if the payment terms are not satisfied, commercial mortgage loans are nonrecourse loans. This means that the lender can only look to the income-producing property backing the loan for interest and principal repayment.

Thus, the unique economic characteristics of each income-producing property in a pool backing a CMBS deal require that a credit analysis be performed on a loan-by-loan basis. This analysis should not only be performed at the time of issuance, but also monitored on an on-going basis. Finally, the analysis of CMBS should consider three major differences between RMBS and CMBS due to the features of the underlying loans. These differences are described below in detail.

First, 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.

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 fashioned. More specifically, typically potential buyers of the junior bond classes are first sought after by the issuer before the deal is structured. The potential buyers first evaluate the proposed pool of mortgage loans and in the evaluation process may, depending on market demand for CMBS product, request the elimination of some loans from the pool. This segment in the structuring process, which one does not discover in RMBS transactions, thus providing 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.