CMBS deals show less diversity, higher leverage. (Commercial).

ACCORDING TO NEW YORK-BASED MOODY'S Investors Services' quarterly review of the U.S. commercial mortgage-backed securities (CMBS) market, CMBS 1Q03: Twin Trends of Rising Conduit LTV and Falling Deal Diversity Pose Credit Challenges, CMBS deals in the first quarter of 2003 showed less diversity and higher leverage than previously.

"The average Moody's loan-to-value [LTV] for conduit loans was 90.5 percent, and this is the first time the average has been in excess of 90 percent since our study commenced in 1998. Seven percent of the first-quarter 2003 loans exceeded 100 percent Moody's LTV, the highest level since the third quarter of 1999," said Tad Philipp, Moody's managing director for CMBS and author of the report.

During the first quarter, fusion deals were the predominant format of CMBS issuance, comprising approximately one-third of the number of deals and about half the dollar volume, according to Moody's. Fusion deals blend a portion of conduit loans, traditionally higher-leveraged small loans, with large loans that typically have lower leverage.

"The two main trends impacting the credit quality of recent fusion deals are the increase in leverage of the conduit portion and a decrease in diversity. In combination, these two characteristics can lead to the possibility of increased rating volatility for investors unless appropriately addressed through additional credit support," Philipp said.

According to Moody's, it is concerned that the combination of ever-larger loans and ever-thinner mezzanine class sizes will lead to a new level of rating volatility for CMBS that is inconsistent with what has occurred in the past and with the expectations of many investors.

For the first quarter of 2003, CMBS delinquencies reached historically high, but generally manageable, levels, Moody's reported.

"Based on our first-quarter 2003 Red-Yellow-Green"' Update report, we see early signs of a bottoming-out process, yet delinquencies may still have some room to rise over the next few quarters as the economy and demand for real estate space remain soft," Philipp said.

One clear and dramatic trend Moody's found is the delinquency rates for health care and lodging sectors have significantly departed from the performance of the other four core asset classes. For several years, through late 1999, the performance of all of the CMBS asset classes traveled together in a fairly tight pack, with the spread in delinquency rates at or below 1 percent. Health care broke away from the core asset pack in late 1999, rising to near double-digit levels two years ago, where it still currently resides, according to Moody's.

"Hotel delinquencies started separating from the core asset pack toward yearend 2000, but they leveled off at around 2 percent until the third quarter of 2001. Following the terrorist attacks, hotel delinquencies spiked up to the percent to 7 percent range where they now remain," said Philipp.

Performance for the core asset classes (multifamily, retail, industrial and office) continues to run within a i percent band, as is historically the case, Moody's reports. "There has been a steady rise in the core delinquency rate over the past few years that we believe still has a few more quarters to run until all of the lagging factors from the downturn have worked their way through the system," said Philipp.

Five months after its passage, the Terrorism Risk Insurance Act (TRIA) has begun to have its intended effect. Rates for terrorism coverage have abated from the sky-high levels of a year ago. Additionally, per occurrence language has returned versus the more stingy aggregate limits that affected many policies immediately post-Sept. 11.

Coverage for domestic terrorism is beginning to reappear as well, at reasonable cost in some cases and for no cost in others. "Even for office properties in Manhattan, there has been an improvement in the availability and affordability of terrorism insurance. Leading insurance brokers with whom we have consulted report quotes coming in for terrorism insurance at 10 percent to 30 percent of the cost of a property's overall property and casualty (P&C) policy. These levels are half or less of where they were one year ago," said Philipp.

According to Moody's, the most noteworthy monitoring trend for the first quarter is that upgrades and downgrades were evenly balanced following several quarters in which downgrades exceeded upgrades. In prior quarters, as the downturn was clearly under way, there were more signals for downward credit drift, and the ratio of upgrades to downgrades reversed for the first time.