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IFT Notes for Level I CFA® Program

LM04 An Introduction to Asset-Backed Securities

Part 5

7. Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial mortgage loans on income-producing property. Important features of a CMBS are as follows:

  • The underlying are loans to purchase or refinance a commercial property such as a warehouse, apartment building, office building, hotels, health care facilities etc.
  • Commercial mortgage loans are non-recourse loans. Lenders can only stake a claim to the income-producing property backing the loan in case of a default and not on any other asset of the borrower.
  • It is important to study the cash flows from the underlying properties for credit analysis.
  • There are two key indicators to assess the potential credit performance of a commercial mortgage loan: 1) debt-to-service coverage ratio and 2) the loan-to-value ratio.
    Debt-to-service coverage ratio = \frac{\text{Annual net operating income}}{\text{Debt service}}


    Debt service = annual interest payment and principal repayment

    Net operating income = rental income – cash operating expenses – a non-cash replacement reserve

    If DSC > 1.0, then cash flows from property are sufficient to service debt.

How to interpret DSC and LTV ratios:

  • The higher the DSC ratio, the lower the credit risk and better is the borrower’s ability to service debt.
  • A low loan-to-value ratio implies lower credit risk.
  • Note: to memorize this formula, draw a parallel with interest coverage ratio from FRA.


7.1 Credit Risk

The role of a credit-rating agency in the CMBS market is to give an opinion on the credit-quality of the bond and provide any enhancement to achieve a desired credit rating. For example, if specific DSC and LTV ratios are needed and those ratios cannot be met at the loan level, then subordination is used to achieve the desired credit rating.

7.2 CMBS Structure

Interest and principal repayments in a CMBS are structured as follows:

  • Interest on principal outstanding is paid to all tranches.
  • The highest-rated bonds are paid off first in the CMBS structure.
  • Losses arising from loan defaults are charged against the principal balance of the lowest priority CMBS tranche outstanding. These tranches may be unrated by credit-rating agencies and are called the “first-loss piece”, “residual tranche”, or “equity tranche”.

Characteristics of a CMBS Structure

In this section, we look at two important characteristics of a CMBS structure: call protection and balloon risk.

Call Protection

RMBS investors are exposed to prepayment risk since the borrowers have a right to prepay and are not penalized for prepayment; they have an incentive to prepay. CMBS has considerable call protection, which is protection against early prepayment of mortgage principal. The call protection comes in two forms: at the structure level and at the loan level.

Call protection at the structural level:

Call protection at the structural level comes by structuring CMBS into sequential-pay tranches, by credit rating. A lower-rated tranche cannot be paid off until the higher-rated tranches are retired. But, in the case of a default, the losses must be charged to the lowest-rated tranche first and last to the highest-rated tranche.

Call protection at the loan level:

There are four mechanisms that offer investors call protection at the loan level:

  1. Prepayment lockouts: The borrower is prohibited from any prepayments during a specific period of time.
  2. Prepayment penalty points: The borrower must pay a fixed percentage of the outstanding loan balance as prepayment penalty if he wishes to refinance.
  3. Yield maintenance charges: Also known as “make-whole charge”. The borrower must pay a penalty to the lender that makes refinancing uneconomical if the sole objective was to get a lower mortgage rate.
  4. Defeasance: Defeasance is a protection at the loan level that requires the borrower to provide sufficient funds that can be invested in a portfolio of government securities to replicate the cash flows in the absence of prepayments.

Balloon Risk

Residential mortgages are fully-amortizing loans that are fully amortized over a long period of time. Usually, there is no principal outstanding after the last mortgage payment. But, many commercial loans backing CMBS transactions are balloon loans which require a substantial principal payment on the final maturity date. If the borrower is not able to make the lump sum payment, he may ask for an extension of the loan over a period of time called the “workout period”.

Balloon risk is a type of extension risk. The risk that a borrower will not be able to make the balloon payment either because the borrower cannot arrange for refinancing or cannot sell the property to generate sufficient funds to pay off the balloon balance is called “balloon risk”.

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