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Commercial mortgage-backed security

From Wikipedia, the free encyclopedia

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.[1]

CMBS issues are usually structured as multiple tranches, similar to collateralized mortgage obligations (CMO), rather than typical residential "passthroughs."[citation needed] The typical structure for the securitization of commercial real estate loans is a real estate mortgage investment conduit (REMIC), a creation of the tax law that allows the trust to be a pass-through entity which is not subject to tax at the trust level.

Many American CMBSs carry less prepayment risk than other MBS types, thanks to the structure of commercial mortgages. Commercial mortgages often contain lockout provisions after which they can be subject to defeasance, yield maintenance and prepayment penalties to protect bondholders. European CMBS issues typically have less prepayment protection. Interest on the bonds may be a fixed rate or a floating rate, i.e. based on a benchmark (like LIBOR/EURIBOR) plus a spread.

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  • ✪ Understanding CMBS Loans / Conduit Mortgages
  • ✪ Navigating the Treacherous CMBS Landscape

Transcription

Welcome to my presentation on mortgage-backed securities. Let's get started. And this is going to be part of a whole new series of presentations, because I think what's happening right now in the credit markets is pretty significant from, I guess, a personal finance point of view and just from a historic point of view. And I want to do a whole set of videos just so people understand, I guess, how everything fits together, and what the possible repercussions could be. But we have to start with the basics. So what is a mortgage-backed security? You've probably read a lot about these. So historically, let's think about what historically happens when I went to get a loan for a house, let's say, 20 years ago. And I'm going to simplify some things. And later we can do a more nuanced. Where'd my pen go? Let's say I need $100,000. No, let me say $1 million, because that's actually closer to how much houses cost now. Let's say I need a $1 million loan to buy a house, right? This is going to be a mortgage that's going to be backed by my house. And when I say backed by my house, or secured by my house, that means that I'm going to borrow $1 million from a bank, and if I can't pay back the loan, then the bank gets my house. That's all it means. And oftentimes it'll only be secured by the house, which means that I could just give them back the keys. They get the house and I have no other responsibility, but of course my credit gets messed up. But I need a $1 million loan. The traditional way I got a $1 million loan is I would go and talk to the bank. This is the bank. They have the money. And then they would give me $1 million and I would pay them some type of interest. I'll make up a number. The interest rates obviously change, and we'll do future presentations on what causes the interest rates to change. But let's say I would pay them 10% interest. And for the sake of simplicity, I'm going to assume that the loans in this presentation are interest-only loans. In a traditional mortgage, you actually, your payment has some part interest and some part principal. Principal is actually when you're paying down the loan. The math is a little bit more difficult with that, so what we're going to do in this case is assume that I only pay the interest portion, and at the end of the loan I pay the whole loan amount. So let's say that this is a 10-year loan. So for each year of the 10 years, I'm going to pay $100,000 in interest. $100,000 per year, right? And then in year 10, I'm going to pay the $100,000 and I'm also going to pay back the $1 million. Right? Year 1, 2, 3, dot, dot, dot, dot, 9, 10. So in year one, I pay $100,000. Year two, I pay $100,000. Year three, I pay $100,000. Dot, dot, dot, dot. Year nine, I pay $100,000. And then year 10, I pay the $100,000 plus I pay back the $1 million. So I pay back $1.1 million. So that's kind of how the cash is going to be transferred between me and the bank. And this is how a-- I don't want to say a traditional loan, because this isn't a traditional loan, an interest-only loan-- but for the sake of this presentation, how it's different than a mortgage-backed security, the important thing to realize is that the bank would have kept the loan. These payments I would have been making would have been directly to the bank. And that's what the business that, historically, banks were in. Another person, you-- and you have a hat-- let's say you're extremely wealthy and you would put $1 million into the bank. Right? That's just your life savings or you inherited it from your uncle. And the bank would pay you, I don't know, 5%. And then take that $1 million, give it to me, and get 10% on what I just borrowed. And then the bank makes the difference, right? It's paying you 5% percent and then it's getting 10% from me. And we can go later into how they can pull this off, like what happens when you have to withdraw the money, et cetera, et cetera. But the important thing to realize is that these payments I make are to the bank. That's how loans worked before the mortgage-backed security industry really got developed. Now let's do the example with a mortgage-backed security. Now there's still me. I still exist. And I still need $1 million. Let's say I still go to the bank. Let's say I go to the bank. The bank is still there. And like before, the bank gives me $1 million. And then I give the bank 10% per year. Right? So it looks very similar to our old model. But in the old model, the bank would keep these payments itself. And that $1 million it had is now used to pay for my house. Then there was an innovation. Instead of having to get more deposits in order to keep giving out loans, the bank said, well, why don't I sell these loans to a third party and let them do something with it? And I know that that might be a little confusing. How do you sell a loan? Well let's say there's me. And let's say there's a thousand of me. Right? There's a bunch of Sals in the world. Right? And we each are borrowing money from the bank. So there's a thousand of me. Right? I'm just saying any kind of large number. It doesn't have to be a thousand. And collectively we have borrowed a thousand times a million. So we've collectively borrowed $1 billion from the bank. And we are collectively paying 10% on that, right? Because each of us are going to pay 10% per year, so we're each going to pay 10% on that $1 billion. Right? So 10% on that $1 billion is $100 million in interest. So this 10% equals $100 million. Now the bank says, OK, all the $1 billion that I had in my vaults, or whatever-- I guess now there's no physical money, but in my databases-- is now out in people's pockets. I want to get more money. So what the bank does is it takes all these loans together, that $1 billion in loans, and it says, hey, investment bank-- so that's another bank-- why don't you give me $1 billion? So the investment bank gives them $1 billion. And then instead of me and the other thousands of me paying the money to this bank, we're now paying it to this new party, right? I'm making my picture very confusing. So what just happened? When this bank sold the loans-- grouped all of the loans together and it folded it into a big, kind of did it on a wholesale basis-- it's sold a thousand loans to this bank. So this bank paid $1 billion for the right to get the interest and principal payment on those loans. So all that happened is, this guy got the cash and then this bank will now get the set of payments. So you might wonder, why did this bank do it? Well I kind of glazed over the details, but he probably got a lot of fees for doing this, or maybe he just likes giving loans to his customers, whatever. But the actual right answer is that he got fees for doing this. And he's actually probably going to transfer a little bit less value to this guy. Now, hopefully you understand the notion of actually transferring the loan. This guy pays money and now the payments are essentially going to be funnelled to him. I only have two minutes left in this presentation, so in the next presentation I'm going to focus on what this guy can now do with the loan to turn it into a mortgage-backed security. And this guy's an investment bank instead of a commercial bank. That detail is not that important in understanding what a mortgage-backed security is, but that will have to wait until the next presentation. See you soon.

Contents

Organization

The following is a descriptive passage from the "Borrower Guide to CMBS" published by the Commercial Mortgage Securities Association and the Mortgage Banker's Association:[2]

Commercial real estate first mortgage debt is generally broken down into two basic categories: (1) loans to be securitized ("CMBS loans") and (2) portfolio loans. Portfolio loans are originated by a lender and held on its balance sheet through maturity.

In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled and transferred to a trust. The trust issues a series of bonds that may vary in yield, duration and payment priority. Nationally recognized rating agencies then assign credit ratings to the various bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is subordinate to the lowest rated bond class.

Investors choose which CMBS bonds to purchase based on the level of credit risk/yield/duration that they seek. Each month the interest received from all of the pooled loans is paid to the investors, starting with those investors holding the highest rated bonds, until all accrued interest on those bonds is paid. Then interest is paid to the holders of the next highest rated bonds and so on. The same thing occurs with principal as payments are received.

This sequential payment structure is generally referred to as the "waterfall". If there is a shortfall in contractual loan payments from the Borrowers or if loan collateral is liquidated and does not generate sufficient proceeds to meet payments on all bond classes, the investors in the most subordinate bond class will incur a loss with further losses impacting more senior classes in reverse order of priority.

The typical structure for the securitization of commercial real estate loans is a real estate mortgage investment conduit (REMIC). A REMIC is a creation of the tax law that allows the trust to be a pass-through entity which is not subject to tax at the trust level. The CMBS transaction is structured and priced based on the assumption that it will not be subject to tax with respect to its activities; therefore, compliance with REMIC regulations is essential. CMBS has become an attractive capital source for commercial mortgage lending because the bonds backed by a pool of loans are generally worth more than the sum of the value of the whole loans. The enhanced liquidity and structure of CMBS attracts a broader range of investors to the commercial mortgage market. This value creation effect allows loans intended for securitization to be aggressively priced, benefiting Borrowers.

Industry participants

Primary servicer (or sub-servicer)

(Also see primary servicer) In some cases the borrower may deal with a primary servicer that may also be the loan originator or mortgage banker who sourced the loan. The primary servicer maintains the direct borrower contact, and the master servicer may sub-contract certain loan administration duties to the primary or sub-servicer.

Master servicer

The master servicer’s responsibility is to service the loans in the pool through to maturity unless the borrower defaults. The master servicer manages the flow of payments and information and is responsible for the ongoing interaction with the performing borrower.

Special servicer

(Also see special servicer) Upon the occurrence of certain specified events, primarily a default, the administration of the loan is transferred to the special servicer. Besides handling defaulted loans, the special servicer also has approval authority over material servicing actions, such as loan assumptions.

Directing certificateholder / controlling class / B-piece buyer

The most subordinate bond class outstanding at any given point is considered to be the directing certificateholder, also referred to as the controlling class. The investor in the most subordinate bond classes is commonly referred to as the "B-piece buyer". B-piece buyers generally purchase the B-rated and BB/Ba-rated bond classes along with the unrated class.

Trustee

The trustee’s primary role is to hold all the loan documents and distribute payments received from the master servicer to the bondholders. Although the trustee is typically given broad authority with respect to certain aspects of the loan under the Pooling and Servicing Agreement (PSA), the trustee typically delegates its authority to either the special servicer or the master servicer.

Rating agency

There will be as few as one and as many as four rating agencies involved in rating a securitization. Rating agencies establish bond ratings for each bond class at the time the securitization is closed. They also monitor the pool’s performance and update ratings for investors based on performance, delinquency and potential loss events affecting the loans within the trust.

See also

References

  1. ^ Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 4 (Thomson West, 2017 ed.).
  2. ^ "Borrower guide to CMBS" (PDF). Archived from the original (PDF) on 2006-05-15.

External links

This page was last edited on 6 February 2018, at 15:32
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