CR E Finance Council: CMBS E-Primer Chapter 5.3: Investing in CMBS 10 The Impact of Prepayments on CMBS IOs ‘When evaluating CMBS IOs, the market examines what is known as the "prepay slope," which is simply the difference in spreadiyield between the 0% CPY and 100% CPY scenarios. The slope of a CMBS IO captures the degree of call protection on the underlying commercial loans that comprise a conduit transaction’s collateral pool. Specifically, it reflects the proximity and duration of the open period across the collateral pool. For example, a WAC, Support or XA IO with a slope of 200 by will tend to have less stringent prepayment protection in force than an IO with a slope of 40 bp. In general, older-vintage IOs have higher slopes than more recent vintage deals. In mid-1990 vintage deals, itis not uncommon to see ‘open periods as long as 24 months, whereas current origination practices enforce a significantly shorter ‘open period not exceeding 6 months Generally, a more exaggerated slope on a more seasoned 10 is due not only to its seasoning, but also to the less stringent and less consistent prepayment lockout periods in older vintage IOs versus today’s. Clearly, investors wishing to take advantage of what is viewed as an overly conservative pricing assumption for 10 would focus on more seasoned IOs given their upside potential should prepayments during the open period come in slower than the pricing assumption of 100% CPY. Of course, the prepay slope is only one metric useful for CMBS IO analysis, Investors also need to examine the prepayment protection in individual loans, particularly the larger ones, and the economic viability of the underlying collateral being refinanced, considering such issues as the current interest rate environment and the potential cash takeout 2 lable to the borrower via refinancing, Call-Protection Trends In addition to the decrease in the open period, the type of prepayment protection present in conduit transactions has shifted over the years. From 1995 through late-1997, a vast majority of CMBS. transactions had hard prepayment lockout periods, followed by yield maintenance and fixed penalties, Lockout legally prohibits borrowers from prepaying during the lockout period, which generally lasts two to three years. Yield maintenance usually follows the lockout period and is designed to create a strong economic disincentive for the borrower to prepay. The yield maintenance penalty is designed to ensure that the same yield is received as would be the case if all scheduled mortgage payments until the loan's ‘maturity were paid. In response to investors’ stated desires for more stable cashflows, most recent CMBS transactions are collateralized by commercial mortgage loans that provide for lockout and defeasance, with yield ‘maintenance become much less common, Defeasance allows a borrower to prepay a loan without altering CMBS cashflows to investors. Defeasance requires that a borrower replace the prepaid loan with a series of U. S. Treasury strips that mimics the cashflow stream of the mortgage loan, eliminating the cashflow volatility normally caused by prepayments. Note that an event of defeasance is transparent from a deal cashflow perspective. For this reason, a loan that is prepay-protected via lockout and defeasance ‘generally is presented to investors as a "locked-out” loan. When a loan in a CMBS pool is defeased, it tends to enhance the overall credit quality of the pool as it replaces commercial mortgage assets with U.S. government guaranteed Treasury strips. However, such stability does come at a cost, as it eliminates the potential positive impact on yield via prepayment penalties Allocation of Prepayment Penalties to CMBS Classes © 2013 CRE Finance Council. All rights reserved. 6CR E Finance Council: CMBS E-Primer Chapter 5.3: Investing in CMBS 10 ‘The methodology for allocating prepayment penalties has shifted over the years as well. Prior to 1997, 75% to 100% of the prepayment penalty was allocated to the 10 with 0% to 25% allocated to the class, currently receiving principal (the current-pay bond). More recently, prepayment penalties are allocated such that the current-pay bond is approximately made whole and the remaining penalties distributed to the IO. This is known as "base interest fraction” allocation. Under this methodology, the current-pay bond is, ‘compensated for the early return of principal in a environment where rates are lower than at origination. ‘The base interest fraction allocation attempts to establish a proxy for bond-level yield maintenance, whereby the investor’s realized yield is in line with the yield that would have been attained had the prepayment not occurred, Generally speaking, the base interest fraction methodology leaves a significant pottion of the yield maintenance penalty available for the TO classes. Analysis of CMBS 10's Upside Potential, Given Embedded Prepayment Penalties While the payment of yield maintenance penalties does create cashflow volatility, this method of prepayment protection can represent a windfall to 10 investors. Should prepayments occur during yeild ‘maintenance period, the present value of the yield maintenance penalty paid to the 10 is oftentimes greater than the present value of the excess interest that would have been received from the loan had it not prepaid. Although, in a rising interest rate environment a lesser yield maintenance penalty would be paid, however the offset is that prepayments should be slower given the higher rates available at refinancing In this case, the 10 is negatively impacted as the prepayment reduc However, most loans originated with yield maintenance provisions require a minimum prepayment penalty of 1%, and this tends to soften the detrimental effects of prepayments in high interest rate environments. Furthermore, while a formal OAS (option-adjusted spread) model for CMBS collateral is nonexistent at this time, the income stream due to the IO. , in theory, a high interest rate environment would dissuade refinancing, suggesting that the upside benefit of yield maintenance to a CMBS IO may exceed the downside. The Impact of Defaults on CMBS 10 Even though CMBS 10s hold a senior position in a deal's cashflow waterfall, any reduction in their notional balances from involuntary principal payments or write-downs represents a risk. Involuntary prepayments and write-downs are particularly damaging because the concomitant loss of notional principal is not offset by prepayment penalties. The current market convention for analyzing CMBS IOs is to assume no defaults until month 25 and then a 3% CDR thereafter. ‘The convention also assumes a 12-month recovery period after default and a 35% loss severity. The Impact of Loan Extensions on CMBS 10s Another condition to consider when evaluating CMBS IOs is the potential for loan extension. If a default ‘occurs at a Joan's balloon date, the repayment of the loan may be extended beyond its original term. This ‘creates a counterintuitive situation in which the delinquency of the balloon payment and the subsequent extension of the loan actually improve the returns to the IO security, as the extension allows the IO to remain outstanding longer. Thus, the fewer the number of defaults in a given pool and the later they ‘occur in a CMBS's life, the better the performance of the transaction's IO classes. RBS Greenwich Capital calculates that 9.4% of the loans with scheduled maturity dates of December 2003 or earlier have extended, We would advise investors wishing to analyze the impact of Ioan extensions on CMBS IO to © 2013 CRE Finance Council. All rights reserved 7