115 CFA
File: Fixed Income - Reading 45 - 6. Commercial Mortgage-Backed Securities

6. Commercial Mortgage-Backed Securities

g. describe the characteristics and risks of commercial mortgage-backed securities;

What is a commercial Mortgage-backed security (CMBS)?
Commercial mortgage-backed securities are securitizations of mortgage loans backed by commercial real estate.

What is a debt-to-service coverage ratio?
The debt-to-service coverage ratio (DSC) is net operating income / debt service. Loans with a debt service coverage ratio above 1.00 have a lower likelihood of default because they have a built-in excess cash flow buffer available; this would have to erode before the borrower would experience losses and consider defaulting.

What is a loan-to-value ratio?
The loan-to-value ratio (LTV) is the ratio of loan amount to the value of the collateral property. A lower LTV loan is considered more creditworthy due to its better default protection.

What is the major structural component of a commercial mortgage-backed security (CMBS)?
Credit tranching. There are multiple support tranches, and when delinquencies and defaults occur, cash flows otherwise due to the subordinated class are diverted to the senior classes to the extent required to meet scheduled principal and interest payments.

What is Treasury make-whole (yield maintenance)?
Treasury make-whole (yield maintenance) is a common form of prepayment penalty that requires the borrower to accompany any prepayment with a premium which, when reinvested by the loan owner in Treasuries for the remaining term of the loan (had it not been prepaid), would exactly recreate the lost yield on the prepaid loan.

What are Fixed-percentage prepayment penalties?
Fixed-percentage prepayment penalties require the prepaying borrower to pay a premium equal to a set of percentages of the balance being prepaid.

What is Treasury defeasance?
Treasury defeasance is similar to Treasury yield maintenance in that, instead of prepaying the loan, the borrower substitutes Treasury securities to replicate the cash flows of the mortgage.

What two credit issues do investors face with commercial mortgage-backed securities (CMBS)?
- Operational defaults - the risk that the property will not generate sufficient cash flow to make the monthly payments on the mortgage loan
- Refinance risk - the risk that, at maturity, the property will lack sufficient value to be sold or refinanced in an amount sufficient to make the balloon payment

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