06 12-10-ms-cmbs market insights


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06 12-10-ms-cmbs market insights

  1. 1. MORGAN STANLEY RESEARCH Morgan Stanley & Co. Richard Parkus Incorporated richard.parkus@morganstanley.com +1 212 761 1444 Morgan Stanley & Co. Andy Bernard Incorporated andrew.bernard@morganstanley.com +1 212 761 7880 December 6, 2010 CMBS StrategyGlobal CMBS Market Insights CRE Debt Markets: Challenges and Opportunities A promising new foundation for the CMBS market is Morgan Stanley CMBS Strategy Projected Base emerging. We believe that a revitalized CMBS market will Case Loss Distributions be critical in dealing with the nearly $1.4 trillion of % commercial real estate loans maturing over the next three Base Case Loss Distributions for CMBX Series 25 years, and the $2.8 trillion maturing through 2020. The decade of deleveraging has begun. Opportunities abound. 20 Financing markets: Commercial real estate financing markets have effectively recovered for large, institutional- 15 quality real estate assets, but remain highly dislocated for 10 smaller properties. Significant improvement in the latter will likely take several more years. 5 Credit performance: In our view, and contrary to that of many market participants, the credit performance of 0 CMBX.1 CMBX.2 CMBX.3 CMBX.4 CMBX.5 legacy CMBS loans is not yet improving. Much of the Source: Morgan Stanley Research apparent improvement simply reflects the effects of the significant increases in both liquidations and loan Comparison with NAIC Loss Projections modifications. We expect new defaults to remain highly Scenario CMBX.1 CMBX.2 CMBX.3 CMBX.4 CMBX.5 elevated for at least another 12-18 months, and possibly NAIC 6.7 7.2 10.3 12.0 9.8 longer. MS Bear Case 7.6 9.6 12.7 16.5 13.2 MS Base Case 6.3 8.2 11.0 14.5 11.6 Fundamentals: The deterioration in fundamentals across MS Bull Case 5.1 5.7 8.0 10.6 8.3 Source: NAIC, Morgan Stanley Research the major property segments (office, industrial and retail) has slowed significantly, and we believe that it is likely to stabilize over the next 12-18 months. However, we think that robust NOI growth is several years away. Morgan Stanley CMBS credit models: Loss projections from our newly developed loan-level credit models, which incorporate loan modifications, are previewed. Our Base Case loss projections are higher than those of the NAIC, while our Bull Case loss projections are slightly lower. Morgan Stanley does and seeks to do business with Trade Ideas: companies covered in Morgan Stanley Research. As • Buy the AM.3 and AM.5 indices a result, investors should be aware that the firm may have a conflict of interest that could affect the • Buy AJ.1 and AJ.2 reference cash bonds objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a • Buy 2005 and early 2006 AA cash bonds single factor in making their investment decision. selectively For analyst certification and other important • Buy new issue credit bonds over 2007 senior disclosures, refer to the Disclosure Section, bonds located at the end of this report.
  2. 2. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market InsightsCMBS Market InsightsCRE Debt Markets: Challenges and OpportunitiesRichard Parkus (212) 761-1444 On the other hand, given that we are nearing the bottom ofAndy Bernard (212) 761-7880 one of the worst cycles in commercial real estate history, we believe that this is a particularly opportune time for newUS commercial real estate debt markets are now investment ideas, both debt and equity, distressed and non-approximately 24 months into what is unequivocally the 1 distressed. For commercial real estate debt, in particular,worst downturn since the early 1990s, and possibly longer. loans originated at the bottom of cycles have consistentlyDuring this period, commercial real estate prices fell 30-60%, experienced lower losses than loans originated at otherrents plummeted and vacancy rates ballooned, in many 2 parts, typically by significant margins.cases surpassing previous highs set in the early 1990s. Asfundamentals weakened dramatically and financing markets We believe that the recovery is likely to be propelled, in part,all but shut down, the performance of commercial real estate by a revitalized CMBS market, which is now emerging. Whiledebt deteriorated at a pace far exceeding even that CMBS new issue volume was only about $10 billion in 2010experienced during the early 1990s. (compared to $223 billion in 2007), it is likely to seeExhibit 1 significant growth in 2011 and beyond. Moreover,CRE Prices Declined 44% Peak to Trough experimentation is already underway in new CMBS deals to modify structures to address aspects of legacy loans and Moodys CPPI Index Case-Shiller 20 City Composite Index deals that are proving to be highly problematic in the current 215 environment. 195 With Morgan Stanley re-launching coverage of CMBS, this 175 report sets out, in some detail, our views on the most Index Values important issues facing the sector. The following is a 155 synopsis of our views: 135 44% decline • Commercial real estate financing markets have effectively 115 4% range recovered for large, institutional-quality real estate assets, range but remain highly dislocated for smaller properties. 95 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 Significant improvement in the latter will likely take several more years.Source: Moody’s, Standard and Poor’s, Morgan Stanley ResearchWith the deterioration in fundamentals likely to stabilize in • Contrary to the view of many market participants, the credit2011, in our view, at least for the most part, and financing performance of legacy CMBS loans has shown little or nomarkets exhibiting significant improvement, particularly for improvement to date. Much of the apparent improvementinstitutional-quality assets, commercial real estate is set to simply reflects the large increases in both loan liquidationsenter the recovery phase. Nevertheless, a vast swath of the and modifications. Moreover, we expect the default rate tocommercial real estate market must undergo significant remain highly elevated for another 12-18 months, anddeleveraging, and this process has only just begun. The possibly longer.deleveraging process is likely to be slow, requiring several • As the resolution of problem loans enters a new andyears, and painful, given the enormous amount of excess accelerated phase, clear patterns are beginning to emergeleverage and the likely slow pace of improvement in about special servicers’ decisions regarding modificationfundamentals. and liquidation. Special servicers display a strong preference for modifying larger loans (> $15 million), even1 Here, the start of the downturn in CRE debt markets is informally identified with the initial those exhibiting DSCRs below 1.0x. Smaller loans with onset of severe deterioration in CMBS loan performance in September 2008. DSCRs below 1.0x tend to be liquidated, often through note2 According to the MIT’s TBI (Transactions-Based Index), commercial real estate prices, in aggregate, declined by approximately 25% peak to trough during the early 1990s, far less sales, while those with DSCRs above 1.1x have a better than the current price declines. chance of being modified. 2
  3. 3. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market Insights• In most modifications to date, borrowers appear to be transactions are luring many into the misconception that committing some amount of new equity. However, in some financing markets are normalizing and property prices are on cases, the new equity comes with such preferential the mend. In our view, this is a very incomplete picture. treatment that the benefits to the lenders appear to be quite During the initial phase of the downturn, mid-2008 through modest at best. mid-2009, financing virtually disappeared for larger assets as• With the exception of apartment and hotel, which are lending activity by securitization programs, life companies experiencing significant improvements, the deterioration in and even bank syndicated loan desks ground to a halt. fundamentals across the major property segments – office, Financing for smaller loans (less than $20 million), however, industrial and retail – has slowed significantly, and will likely fared somewhat better; while the pullback of securitization stabilize over the next 12-18 months. However, lending did create a sizeable dislocation, approximately 60- improvements in property NOIs will, in many cases, be 70% of smaller maturing loans were ultimately able to secure 3 painfully slow due to long-term leases. financing, largely via regional and community banks.• The maturity wall remains largely intact in CMBS and will By 3Q09, with financial markets thawing and the economy present challenges over the next three years as some of close to a bottom, interest in financing new, conservatively the most over-levered and poorly underwritten loans underwritten commercial real estate loans began to re- mature. emerge. Life companies and large foreign banks, many of them new entrants to the space (e.g., Bank of China and• We expect that CMBS new issue volumes will increase Industrial and Commercial Bank of China), led the way. significantly in 2011 to approximately $35-$45 billion. Much Securitization programs, mortgage REITs, opportunity funds of the source for new lending will be maturing CMBS loans and specialty finance companies soon joined them. that are capable of refinancing and defaulted CMBS loans The focus for all of these lenders was, and remains, almost that are liquidated. exclusively on large, institutional-quality real estate assets.• We preview our newly developed CMBS credit models, Thus, the availability of financing for this segment of the which we will unveil in detail in the near future. Loss commercial real estate market soared. The demand for projections in our base case scenario run from 6.3% for the financing, on the other hand, has remained anemic, due to CMBX.1 to 14.5% for the CMBX.4. The recently released the large percentage of maturing loans that are significantly NAIC loss projections are roughly in line with those of our over-levered and do not qualify for refinancing without credit models under our bull case scenario. additional equity. The confluence of the two effects has created a significant demand-supply imbalance in financing• While the market has rallied relentlessly during much of markets for institutional-quality real estate. The 2010, there remain many attractive opportunities in CMBS, extraordinarily fierce competition for lending opportunities on both in cash and synthetics, in our view. For outright high-quality assets is a sign of this imbalance. synthetic longs, we like AM.3 and AM.5 relative to AM.4. In cash, we like the reference bonds corresponding to the Lending volumes are a poor indicator of credit availability in AJ.1 and AJ.2 indices. Further down in credit, we think that the current environment. While they remain extremely low, select 2005 and early 2006 cash AAs are particularly even for institutional-quality properties, this reflects the lack attractive. Overall, we prefer cash bonds to the synthetic of lending opportunities rather than a lack of willingness on indices, as the synthetic-cash bases remain far wider than the part of lenders. can be justified on fundamental grounds. We prefer The situation in financing markets for smaller commercial seasoned AJs from high-quality 2005 and 2006 deals to real estate assets is very different. Here, the traditional average-quality AMs from 2007 deals. Lower-rated classes sources of financing are regional and community banks (as from new issue deals offer significant value relative to opposed to the global banks) and securitization programs. highly rated classes from 2006 and 2007 deals. Many regional and community banks, however, have seenCRE Financing Markets: A Bifurcated Recovery their loan portfolios severely impacted by commercial real estate-related loan losses. Indeed, regional and communityCommercial real estate financing markets are recovering banks have been negatively affected to a far greater degreefrom the extraordinary degree of paralysis during the depths than the global banks due to their vastly higher exposures –of the crisis. However, the recovery is proving to be highlybifurcated, with some segments showing dramatic 3improvement, and others exhibiting little progress and Most fixed-rate loans that matured during this period had been originated during 1999- 2002, and were likely to have experienced significant price appreciation prior to the recentremaining seriously dislocated. Meanwhile, high-profile downturn. Thus, the difficulty these loans experienced in refinancing predominantly reflected market dislocation rather than inability to qualify. 3
  4. 4. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market Insights 4five to ten times higher for core commercial real estate loans, have been unable to refinance. The results are broken outand five to seven times higher for construction loans. by loan vintage.Unfortunately, the problem of commercial real estate loan Exhibit 3losses for regional and community banks is likely to worsen Recent Vintage Loans Maturing in 2010 Continuedbefore it improves, as many banks are simply delaying the to Experience Difficulty Refinancingdeleveraging problems via widespread term extensions. We Total Loans Maturity Defaults Default Ratethink it is likely that the extension of new credit to commercial Balance Balancereal estate from smaller regional and community banks will Vintage # ($mm) # ($mm) # Balance 1998 26 160 6 31 23% 20%remain well below its normalized level until these institutions 1999 12 100 2 6 17% 6%begin to deal with their problem loans in a meaningful way, 2000 929 4,750 234 1,221 25% 26% 2001 128 503 27 111 21% 22%which could be several years (see Exhibit 2). This is likely to 2002 24 96 3 17 13% 18% 2003 88 1,120 27 592 31% 53%hamper the recovery of smaller real estate assets. 2004 22 486 10 411 45% 84% 2005 467 11,368 199 5,502 43% 48%Exhibit 2 2006 15 669 7 322 47% 48% 2007 29 87 4 42 14% 48%CRE Originations Have Rebounded Quickly at Life Total 1,740 19,339 519 8,254 30% 43%Companies Since the Beginning of 2010, but Source: Intex, Trepp, Morgan Stanley ResearchContinue to Decline at Banks Approximately 43% (by balance) of loans maturing between 700 MBA Quarterly Originations Index January and August 2010 had still not been able to refinance 600 as of September. As would be expected, loans from older vintages experienced less difficulty than loans from more 500 5 recent vintage. Interestingly, large loans (>$50 million) Index Value 400 encountered even more difficulty refinancing during this 300 period than smaller loans (<$10 million). This leads to an 200 important point: while there is intense competition to finance 100 larger, high-quality properties, many of these loans are unable to refinance because they do not qualify, typically 0 2001 4Q02 4Q03 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09 because of excessive leverage. Commercial Banks Life Insurance Companies Conduits Of loans scheduled to mature in 2009, 22% of pre-2005Source: Mortgage Bankers Association vintage loans remained outstanding as of September 2010, while 54% of 2005-07 vintage loans have not paid off.With respect to securitization programs, as already noted,the current focus remains predominantly on larger loans. Exhibit 4 presents an alternative perspective of the 6There are two reasons. First, there is strong investor refinancing data. For each month, the blue line indicates thepreference for higher quality, and thus larger, assets. percentage of loans scheduled to mature in that month thatSecond, accumulating a sufficient amount of smaller loans did not paid off by their maturity dates, e.g., technically,requires more time, given how thinly staffed most maturity defaults. Similarly, the yellow line provides thesecuritization lending programs are at the moment. This percentage of loans scheduled to mature in the given monthincreases the warehousing timeline and thus risk at a time that had still not paid off six months after their maturity date.when hedging warehousing risk is especially problematic, The chart indicates that approximately 50% of maturinggiven the dormant state of the total return swap (TRS) loans do not pay off on time, and 25% have still not paid offmarket. six months after their maturity date.In our view, the recovery of financing markets for smallercommercial real estate properties depends to a much greater 4 The figures are calculated as follows: First, we take the set of all outstanding non-extent on the speed with which the conduit CMBS market defeased conduit loans as of December 2009. From this, we take the total balance of all loans scheduled to mature between January 2010 and August 2010 as the denominator.returns. We have begun to see the re-emergence of The numerator is the total balance of loans scheduled to mature between January and August that had not paid off as of September. Note, for example, that of the 22 loanstraditional conduit loans in the most recent new issue CMBS ($486 million) from the 2004 vintage that were scheduled to mature during the January todeals, and we expect that this trend will continue, but the August period, 10 loans ($411 million) had still not been able to refinance as of September.pace is likely to be slow. 5 Highly seasoned loans experienced much greater property price appreciation prior to the crisis and subsequent price declines.CMBS remittance data clearly reflect the difficulty borrowers 6 The results in Exhibit 4 are constructed as follows: For each month, we first calculate thecontinue to experience in refinancing at maturity. Exhibit 3 set of loans scheduled to mature in that month that are still outstanding and non-defeased as of 12 months before that date. We then calculate the proportion of these loans thatshows the percentage of CMBS loans maturing in 2010 that remain outstanding on the maturity date and six months after the maturity date. 4
  5. 5. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market InsightsExhibit 4 Exhibit 5Only about 50% of Loans Maturing Each Month Trophy Properties Experiencing Much GreaterSince the Onset of the Crisis Have Been Able to Price Appreciation than All Other CategoriesRefinance on Time Price Sub-Indices 210 % % Of Maturing Loans Unable to Refinance RCA 3-city Trophy* Other 190 80 Official CPPI Distressed 170 70 Index Value 1 Month After Maturity 150 60 6 Months After Maturity 130 50 110 40 90 30 70 20 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 10 *Trophy = >$10M, Non-Troubled, NY,DC,SF only; Other = Non-Troubled, Non-Trophy. 0 Source: Geltner Associates LLC, based on data from Real Capital Analytics Inc, & methodology licensed to Real Estate Analytics LLC (REAL), Moody’s, Morgan Stanley 1/07 5/07 9/07 1/08 5/08 9/08 1/09 5/09 9/09 1/10 5/10 9/10 ResearchSource: Intex, Trepp, Morgan Stanley Research Exhibit 6Perhaps the most striking aspect of Exhibit 4, however, is the Significant Differences in Price Changes Since thesuddenness with which financing markets seized up 2009 Bottom for Different Property Categoriesfollowing the events of October 2008. Price Changes 10/07 - 09 Bottom Since 09 Bottom Since 10/07Despite the dramatic improvement in financing markets for CPPI -44% 2% -43% 3-City Trophy -38% 36% -15%institutional-quality properties, refinancing for legacy loans is Distressed -58% 3% -56%likely to become increasingly problematic during 2011-13, as Other -32% 6% -28%the amount of maturing loans from the 2005-08 bubble Source: Geltner Associates LLC, based on data from Real Capital Analytics Inc, & methodology licensed to Real Estate Analytics LLC (REAL), Moody’s, Morgan Stanleyvintages grows significantly, particularly the five-year IO Researchloans.While financing market conditions do not directly affect Loan Performance: No Improvements Yet, andcommercial real estate fundamentals, they do directly impact None Expectedvaluations, and the bifurcated recovery in financing markets The speed of deterioration in CMBS loan performance duringhas had a highly differentiated effect on property valuations. the current downturn has been breathtaking, even inThe Moody’s/REAL CPPI suggests that property prices comparison to the early 1990s. For commercial mortgagesdeclined by 44% between their 2007 peak and 2009 trough, held by life insurance companies, the 60+ day delinquencyand have increased by 2% since that point. On the other 7 rate peaked in June 1992 at 7.53%. The 60+ dayhand, a sub-index of CPPI composed of trophy properties delinquency rate for conduit loans, which reached 7.82% inlocated in New York, Washington DC and San Francisco October, has already surpassed this level. More significantly,declined by 38% peak to 2009 trough, but have appreciated it has done so over a far shorter period. The CMBS 60+ dayby 36% since that time, leaving them only 15% below their delinquency rate increased by approximately 740bp in just2007 peak values. Finally, there are distressed properties two years, while it took insurance company loanswhose prices declined by 58% peak to 2009 trough, and approximately four years to see that degree of deterioration.have appreciated by 3% since then, leaving prices down56% peak-to-current. 7 See ACLI Mortgage Loan Portfolio Profile, June 30, 2010. 5
  6. 6. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market InsightsExhibit 7 become a highly misleading indicator of credit trends. In fact,The Degree and Speed of Deterioration in CMBS as the pace of loan liquidations and modifications is likely toHave Far Exceeded Previous CRE Crashes continue to increase, delinquency rates may well be at or Fixed Rate CMBS Delinquency Rates near their peak for this cycle. 4.0 10 9 To examine credit trends in fixed-rate CMBS loans, we look 3.5 30-Day 60-Day 8 instead at the rate at which loans are becoming delinquent 3.0 that had never been delinquent previously. For example, the Delinquency Rate (%) Delinquency Rate (%) 90+ Day 7 2.5 Matured Delinquent 6 ‘new 30-day’ delinquency rate for a given month reflects only 2.0 Total (RHS) 5 those loans that became 30-days delinquent in that month 4 1.5 that had never been 30-days delinquent prior to that time. 3 1.0 2 The new 30-day delinquency rate represents the new 8 0.5 1 addition to the overall delinquency category each month. 0.0 0 We define the ‘new 60-day’ and ‘new 90-day’ rates Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 analogously. Effectively, they measure the rate at whichSource: Intex, Trepp, Morgan Stanley Research loans are going ‘bad’ and, therefore, more accurately reflectThe fact that delinquency rates have risen so high over such credit trends.a short period reflects, in part, the slow pace at which Exhibit 9 presents the three series for the fixed-rate conduitdelinquent loans have been resolved during the crisis. The CMBS sector. While all three series are volatile on a monthlyslow pace of resolutions is itself the result of the severe basis, there is little evidence to suggest that loandislocation in financing markets. With the availability of credit performance is improving. Rather, the trend rate of flow ofhighly constrained, the sales of REO properties and new loans into 30-day, 60-day and 90-day categoriesdistressed loans have been problematic. appears to have been fairly range-bound since March 2009. While there were several months – March, April and June –Since the onset of the crisis, the aggregate delinquency rate with unusually large inflows (to the 30-day bucket), thesehas grown at a staggering 30-50bp per month, which dwarfs months are probably best thought of as outliers. Recentanything seen previously in either CMBS or life company monthly flows into the new 30-day and new 60-day bucketsportfolios. In July, however, the monthly increase began to are of approximately the same size as the average monthlyslow substantially, and in October it was effectively zero. flows since April 2009, calculated after excluding these threeThis has led to a growing belief in the market that the credit months. This suggests there has been little improvement toperformance of legacy loans is improving markedly. date in the credit performance of legacy loans.Exhibit 8 Exhibit 9The Dramatic Decline in Monthly Increases in the The Rate at Which Loans Are Going Bad Has NotConduit CMBS Delinquency Rate Misleadingly Slowed AppreciablySuggests Improving Loan Performance 90 70 Monthly Change in Delinquency Rate 80 New 30-Day New 60-Day New 90-Day 60 70 50 40 60 Basis Points Basis Points 30 50 20 40 10 30 0 20 -10 -20 10 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 0 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10Source: Intex, Trepp, Morgan Stanley Research Source: Intex, Trepp, Morgan Stanley ResearchIn fact, much of the apparent improvement in loanperformance is the result of a dramatic pick-up since July If loan performance were, in fact, improving one would also2010 in property liquidations, loan sales and modifications, expect to see evidence in the one-month delinquencywhich are net outflows from the pool of delinquent loans.When liquidations and modifications become large relative to 8 That is, any previously current loan moving into the delinquent category must first passthe rate of new delinquencies, simple delinquency rates through the 30-day delinquency bucket, and thus will be reflected in the new 30-day bucket. 6
  7. 7. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market Insights 9transition rates. In particular, the ‘30-to-worse’, ‘60-to-worse’ The $77 billion of non-delinquent loans with DSCRs belowand ‘90-to-90-or-worse’ transition rates would be expected to 1.0x are being supported by some combination of borrowerbe trending downward. These one-month transition rates are equity infusions and reserves. We expect that a significantpresented in Exhibit 10 and again show no sign of proportion of them will ultimately default, as borrowers’improvement. hopes of being rescued by a quick recovery fade.Exhibit 10 Cumulative term defaults to date since the beginning of theDelinquency Transition Rates for Conduit CMBS crisis (September 2008 to present) are in excess of 10% for 10Loans Show Little Sign of Improvement the 2007 and 2008 vintages. We expect that ultimately 11 they will approach, and possibly exceed, the 20% level. Transition Probabilities for Delinquent Conduit Loans Exhibit 12 120 30 to Worse 60 to Worse 90 to 90 or Worse Cumulative Term Default Rates for the 2007 and 100 2008 Vintages Already Exceed 10% and May Roll Rates (%) 80 Ultimately Approach 20% 60 40 Cumulative Defaults Since January 2008 20 12 Cumulative Default Rates (%) 0 10 1/05 1/06 1/07 1/08 1/09 1/10 8Source: Intex, Trepp, Morgan Stanley Research 6In a typical downturn, defaults tend to peak two to threeyears after the recession has ended, and we expect this 4pattern to repeat in the current cycle. Moreover, one does 2not have to look too far to identify prime candidates for futuredefaults: approximately 15.9% ($94 billion) of loans from the 02000-08 vintages have reported DSCRs below 1.0x based 2001 2002 2003 2004 2005 2006 2007 2008on 2009 or 2010 financials. Of these, only 18.2% are Source: Intex, Trepp, Morgan Stanley Researchcurrently delinquent. The growth rate of specially serviced loans has begun toExhibit 11 slow over the past few months. While some of this reflects16% of Conduit Loans Exhibit DSCR < 1.0x, of the significant increase in the rate of loan liquidations andWhich Only 18.2% Are Delinquent, Which Bodes Ill modifications (discussed in detail in the next section), therefor Future Defaults has also been a slowdown in the rate of loans being DSCR < 1.0x Delinquent as transferred to special servicing. Upon closer inspection, Universe DSCR < 1.0x as % of % of DSCR < Vintage Count Bal ($Bn) Count Bal ($Bn) Universe 1.0x however, most of the slowdown has been concentrated in 2000 673 3.2 171 0.8 23.3 37.9 non-delinquent loans being transferred. The rate at which 2001 2,515 13.9 458 2.3 16.6 16.5 delinquent loans are being transferred has exhibited little 2002 2,764 18.5 398 2.1 11.6 17.0 2003 4,139 31.6 478 3.5 11.2 17.7 change. 2004 5,301 49.4 722 5.6 11.3 13.3 2005 9,299 115.2 1,340 14.5 12.6 18.2 2006 11,743 155.4 2,057 24.2 15.6 16.0 2007 11,594 188.6 2,111 39.0 20.7 19.6 2008 804 10.5 166 1.5 14.5 31.2 Total 48,832 586 7,901 94 15.9 18.2Source: Intex, Trepp, Morgan Stanley Research 10 Rates were calculated with respect to original loan balances. 11 In comparison, in "Commercial Mortgage Defaults: An Update," Real Estate Finance, Spring 1999, Esaki, LHeureux and Snyderman estimate that the worst performing vintage of life company loans (the 1986 vintage) experienced cumulative defaults and losses of approximately 36% and 10%, respectively, during the early 1990s. Notice, however, that9 The ‘30-to-worse’ transition rate reflects the proportion of 30-day delinquent loans that above cumulative term defaults statistics for CMBS do not include maturity defaults and move to being 60-days delinquent or worse in the following month. The ‘60-to-worse’ and losses. When these are included, our total loss estimates for the 2006 and 2007 vintages ‘90-to-90-or-worse’ are defined analogously. do indeed exceed that of 1986. 7
  8. 8. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market InsightsExhibit 13 Loan liquidations (including foreclosure sales, REO propertyThe Rate of Specially Serviced Loans Has sales, note sales and discounted payoffs) have acceleratedStabilized, but This Mainly Reflects a Decline in the sharply since June. For fixed-rate conduit loans, there were,Number of Non-Delinquent Loans Being Transferred on average, 70 loans ($383 million) liquidated per month during 1H10. By July this was up to 319 loans ($1,542 Percentage of Fixed-Rate Conduit Loans In Special million), with August and September coming in at 125 ($922 Servicing 12 12 million) and 94 ($1,377 million), respectively. % of Fixed Rate Conduit Loans Exhibit 14 10 Specially Serviced - Total Loan Liquidations Have Risen Significantly Since 8 Specially Serviced - Delinquent July Specially Serviced - Non-Delinquent 6 Fixed Rate Loan Liquidations 350 1,800 4 1,600 300 # of Loans 1,400 # of Liquidated Loans Total Balance ($mm) 2 250 Total Balance (RHS) 1,200 200 1,000 0 01/01 01/02 01/03 01/04 01/05 01/06 01/07 01/08 01/09 01/10 150 800 600 100Source: Intex, Trepp, Morgan Stanley Research 400 50 200The rate of non-delinquent specially serviced loans peaked 0 0at 4.32% ($28.5 billion) in February 2010 and has since 1/05 9/05 5/06 1/07 9/07 5/08 1/09 9/09 5/10declined to 3.53% ($21.7 billion). We expect that the growth Source: Intex, Trepp, Morgan Stanley Researchof non-delinquent specially serviced loans will accelerateagain in the near future. The majority of these loans were The average amount of time required to liquidate defaultedtransferred at the borrower’s request in order to negotiate a loans is a critical factor in determining the value of manyloan modification. There are currently $68.7 billion of non- highly distressed securities, particularly those trading asdefeased fixed-rate loans originated during the bubble period credit IOs. To examine this issue, we first take the subset ofof 2005-08 and originally scheduled to mature during 2011- liquidated loans that had been delinquent prior to liquidation.13. We estimate that approximately 65% of these loans will These loans are classified according to their type ofnot qualify to refinance at maturity, along with many other liquidation: foreclosure sales, REO sales and ‘other’, the 13loans. Many will be transferred to the special servicer for majority of which are note sales.restructuring or liquidation. Exhibit 15 presents the total monthly balance of each type of liquidation since January 2010. While all categories haveResolution of Problem Loans: The Time Has Come risen significantly since July, the ‘other’ category hasBetween September 2008 and June 2010, problem fixed-rate increased disproportionately. We attribute this to theloans poured into special servicers at a remarkable average increase in note sales, as special servicers are embracingrate of 200 ($3.2 billion) per month. As of September 2010, the strategy of auctioning off portfolios of smaller loans as athere were 4,379 fixed-rate conduit loans ($71.7 billion) way of making progress on resolving their massive portfoliosalone at special servicers, 11.7% of the fixed-rate universe. of problem loans. Given the time and cost of the foreclosure route, not to mention the fact that courts in judicialThe dislocation in financing markets in combination with the foreclosure states are overflowing with foreclosure cases,speed with which loans were being transferred to special commercial and residential, we expect that note sales willservicers made it effectively impossible to make significant grow over time, possibly by a significant amount. This, inprogress on resolving problem loans. However, the recent turn, should drive liquidation volumes higher over time.improvement in financing markets, at least for higher-qualityassets, as well as the slowdown in the rate of loans beingtransferred, is now allowing the resolution process to moveforward. 12 Because of the reporting lag, liquidations in a given month typically are not known precisely for several months. 13 In a foreclosure sale, the property is sold at the foreclosure auction. An REO sale occurs when the special servicer credit bids at the foreclosure auction to buy the property and take it REO. The property is then sold at some later point. 8
  9. 9. MORGAN STANLEY RESEARCH December 6, 2010 CMBS Market InsightsExhibit 15 Exhibit 17Liquidations Have Increased Significantly Since Loss Severity Rates for REO Sales Are MuchJuly 2010, Particularly the ‘Other’ Category, Which Higher than for Other Types of LiquidationIncludes Note Sales Loss Severity by Resolution Type Average Monthly Loss Severity (%) 100 Components of Liquidations 90 Foreclosure Sale REO Sale Other 600 80 Foreclosure Sale REO Sale Other 70 500 60 50 Balance ($mm) 400 40 300 30 20 200 10 0 100 1/10 3/10 5/10 7/10 9/10 0 Source: Intex, Trepp, Morgan Stanley Research 1/10 3/10 5/10 7/10 9/10 Loan modifications have also increased significantly duringSource: Intex, Trepp, Morgan Stanley Research 2010, up from an average of 21 loans ($411 million total balance) per month in 2009 to 53 loans ($1,955 million) perExhibit 16 presents (balance-weighted) average liquidation 14 month in 2010, and 77 loans ($2,911 million) since Junetimes by month and liquidation type. Liquidation times 15 2010 (see Exhibit 18).appear to have been experiencing a very modest downwardtrend since mid-year, possibly a reflection of improving Exhibit 18financing markets. Average liquidation times are $23.5 Billion of Modifications ex GGP to Dateapproximately 15-20 months for REO sales, 12-15 months Modifications Ex-GGPfor foreclosure sales and 10 months for note sales. 120 6,000Exhibit 16 100 5,000Average Liquidation Times Are Down Slightly # of Loans Total Balance (RHS)Since the Beginning of 2010 Total Balance ($mm) # of Loans Modified 80 4,000 Resolution Times By Liquidation Type 60 3,000 30 Foreclosure Sale REO Sale Other Resolution Time (Months) 25 40 2,000 20 20 1,000 15 0 0 10 5/05 7/07 9/08 5/09 1/10 9/10 5 Source: Intex, Trepp, Morgan Stanley Research 0 The analysis below examines differences between loans that 1/10 3/10 5/10 7/10 9/10 special servicers chose to modify and loans they chose toSource: Intex, Trepp, Morgan Stanley Research liquidate. Understanding the approach special servicers are taking in determining whether a given loan should be liquidated or modified is a crucial component of valuing legacy bonds. Before proceeding, we note that the information relating to modified loans provided by special servicers is, in our view, inadequate. The precise details for any loan modification should be provided in a timely manner. This includes the14 15 Liquidation time is defined as the time between the date of the loan’s last payment and Exhibit 18 includes modifications from all CMBS sectors, including those modifications the liquidation date. still under investigation for modification type. 9