Benefits of Securitization
The Securitization Process Securitization involves transferring ownership of assets from original owners (usually... Read More
Commercial Mortgage-Backed Securities (CMBS) are backed by a pool of commercial mortgages on income-generating properties such as multi-family properties (e.g., apartments), office buildings, industrial properties, shopping centers, hotels, and healthcare facilities.
In the U.S. and other countries where commercial mortgages are non-recourse loans, the lender can only seize the income-generating property. The lender has no recourse to the borrower’s other assets.
Two key indicators of potential credit performance are the loan-to-value (LTV) ratio and the Debt-Service-Coverage (DSC) ratio. For example, if a lender buys a $1,000,000 property and makes a down payment of $200,000, the loan-to-value ratio will be $800,000/$1,000,000 = 0.8. The lower the LTV, the more the lender is protected for recovering the loaned amount.
The Debt-Service-Coverage (DSC) ratio is calculated as the net operating income generated by the property divided by the interest and principal repaid to the lender. A DSC exceeding 1 indicates that cash flows from the property are sufficient to cover the debt service.
A credit-rating agency determines the level of credit enhancement to achieve the desired credit rating. For instance, if specific LTV and DSC ratios cannot be met at the loan level, subordination could be used to achieve the desired credit rating.
One of the major benefits of Commercial Mortgage-Backed Securities over Residential Mortgage-Backed Securities is the call protection feature, which protects investors against early prepayments. Four mechanisms offer a call protection at the loan level:
Many commercial loans backing CMBS are balloon loans requiring a substantial principal repayment at maturity. If the borrower fails to repay, the lender could extend the loan with a higher default interest rate over a period called the workout period. Thus, the total default risk becomes a “balloon risk.”
Question
Which of the following characteristics are most desirable in a Commercial Mortgage-Backed Secrurity from the point of view of a lender?
- A low loan-to-value ratio and a low debt-service-coverage ratio.
- A low loan-to-value ratio and a high debt-service-coverage ratio.
- A high loan-to-value ratio and a high debt-service-coverage ratio.
Solution
The correct answer is B.
The lower the loan-to-value ratio, the more the lender is protected for recovering the loaned amount. On the other hand, a debt-service-coverage ratio exceeding 1 indicates that cash flows from the property are sufficient to cover the debt service.