Fitch Expects CMBS Loss Severity To Rise Markedly Next Year
As anyone who has spent even a day looking at securitization tranching or CDS trading will tell you, there are two critical components to any investment that involves risky fixed income: cumulative loss probability and loss severity: the first tells about how likely any given security is to default within a given amount of time, while the second determines what the final recovery will be assuming there is an actual even of default. The two are usually tied in very closely, as any (forced) delays in reaching a default state usually come at the expense of exhausting any underlying asset value (and in some cases being primed by additional layer of debt which get a first look on assets in the case of liquidation).
Which is why today's announcement by Fitch that CMBS loss severity is expected to risk markedly next year should be viewed with extreme caution: in essence the artificial delays in bringing the CRE market to fair value in terms of delinquencies and REOs going to foreclosures will simply result in much lower eventual recoveries.
From Fitch, as reprtined from Research Recap:
More than three-fourths (78%) of loan resolutions resulted in no losses to the trust last year. But with commercial real estate debt capital remaining scarce, disposition times will increase to between 24 and 36 months as special servicers are contending with a record backlog of loans (up over 300% since beginning of the year).
‘Special servicers may have to hold certain properties until liquidity returns to the market,’ said Senior Director Britt Johnson. ‘Though recent REMIC reforms may help mitigate loss severities, defaulted loans will take more time to be resolved and losses often will be deferred until maturity.’
Multifamily loans represented an average cumulative loss severity of 38.6% in 2008, with that number likely to increase as many markets have seen increasing levels of unemployment and are suffering from oversupply. Other property types that will see increased loss severities include office (33.3% cumulative average loss in 2008) and hotels (39.5% last year). It should be noted that other property types other than multifamily collectively make up a significantly smaller piece of the CMBS loan universe.
The one area mostly concerning to Fitch is hotel loans:
Additional hotel losses and defaults are likely as sponsors may deplete reserves or discontinue coming out of pocket to pay debt service on underperforming assets,’ said Johnson.
The take home message here is that what is relevant for CMBS is just as relevant for all leveraged loans: the temporary reprieves granted to many leveraged securities will come back to bite investors when defaults eventually pick up again, however with the result being loss rates which will be much higher than default expectations. Frequent Zero Hedge readers will recall CDS auctions from the beginning of the year when many companies would achieve single digit recoveries. The repeat of that phenomenon is only a matter of time as underlying cash flows and asset bases become exhausted. In the meantime, the delay mentality has gripped every asset class. How long, however, can delays persist in an environment of declining cash flows is an open question, and the unpleasant answer to investors is "not much." And when the double whammy of marginal recoveries once again sets in, look for a major correction across all credit markets.