For CMBS Arena, 'The Worst Is Yet to Come'

Fitch Says Loss Rate Hit All-Time High Average of 57% in '09, With More to Follow; Credit Suisse's Dubious Distinction

By LINGLING WEI

In 2007, at the height of the commercial real-estate boom, Credit Suisse Group packaged 250 mortgages into bonds and sold them to investors in a $3.3 billion issue of commercial-mo rtgage-backed securities.

That CMBS issue now has achieved a dubious distinction: The deal is expected to see a 15% loss, the highest potential loss for any 2007 CMBS issue, according to Fitch Ratings. Overall, the projected loss rate on all CMBS issued that year in the U.S. is about 10%, Fitch said.

The story of how some of those loans soured explains why investors, including pension funds, mutual funds and hedge funds, are starting to take their lumps from holding debt on office towers, strip malls and other commercial real estate. While values have shown signs of stabilizing, the weak economy continues to hammer rents and occupancy rates in many markets. As a result, defaults, foreclosures and losses on mortgages are rising.

A spokesman at Credit Suisse declined to comment. The firm exited the CMBS underwriting business in 2008.

CMBS became one of the most favorite forms of real-estate finance during the boom years. Roughly $700 billion of the securities are outstanding, more than the amount of securitized credit-card, student-loan and car-loan debt combined.

Investors have seen a steady rise in defaults for months. The delinquency rate reached 8.4% in June, more than triple the level a year earlier, according to Trepp, a New York company that tracks the commercial-property market.

But other bad news for CMBS investors also is beginning to surface. Historically, when mortgages that were bundled into CMBS run into problems and are foreclosed on or sold, investors have lost, on average, 37% of their principal. But according to a study to be released by Fitch on Wednesday, that figure, known as the "loss-severity rate," averaged 57% last year, an all-time high. The rate will exceed the historical average, through 2011, Fitch projects.

"The worst is yet to come," said Howard Chin, a managing director of the Guardian Life Insurance Co. of America who oversees a CMBS portfolio of about $1 billion.

Mr. Chin believes his portfolio is insulated from losses because he purchased the bonds that had the highest ratings. Analysts estimate the entire loan pool, and not just the loans that experienced difficulty, would have to suffer a loss rate of 30% before the top-tier securities would take a hit. Investors holding bonds with lower ratings won't be as fortunate.

Credit Suisse underwrote the $3.3 billion deal in 2007, which saw a record $210 billion of CMBS issued in the U.S. Typical of the CMBS deals Wall Street sold during the heydays, interest-only loans represent the majority of this Credit Suisse issue. As of March, nearly 18% of the 250 loans underlying the deal were under the care of special servicers, which take over management of CMBS loans when they default or are in danger of imminent default. The losses on those loans have come to about $14.5 million, according to Fitch.

It typically takes months, if not years, for a defaulted loan to be resolved by a servicer.

Property investor Chowdary Yalamanchili last year defaulted on about $160 million in interest-only loans secured by four multifamily properties located in Austin, Texas, and Round Rock, Texas, according to Fitch. The loans were included in the Credit Suisse deal. The 1,417 units in the portfolio were 95% occupied when the loans were made. But occupancy dropped to 65% in early 2009, leading to inadequate cash flow to service the debt, according to Fitch.

Mr. Yalamanchili is working with the servicer to sell the assets, according to Fitch. Mr. Yalamanchili didn't return calls for comment. About 47% of the $160 million in loans likely will be wiped out, according to Fitch.

More recently, also as part of the Credit Suisse issue, a $38.8 million interest-only loan backed by two office properties in Syracuse, N.Y., was transferred to special servicing in light of imminent default, according to Fitch. Most of the leases for the 254,025-square-foot buildings are short term in nature, ranging from three to seven years, the credit rater said. Leases representing 30% of the space are expected to expire this year, and 24% to expire in 2014. Based on a 35% decline in the properties' value, Fitch expects the loan to have a loss of about 19%. The owners of the buildings, including Sid Borenstein and Shimmie Horn, have hired Robert Verrone, a former commercial real-estate banker at Wachovia, to negotiate with the servicer about a loan modification, said Mr. Verrone. The owners referred questions to Mr. Verrone.

In another instance, a $64 million interest-only loan backed by a 828,314-square-foot office property located in the Arts District of Dallas was recently moved to special servicing. The owner, Younan Properties, indicated that cash flow "is insufficient" to cover debt service, according to a Fitch report.

But a Younan spokeswoman disputed that account. She said the loan went to a special servicer because the owner wants to transfer it to "an affiliate." She declined to elaborate, but said: "The property is cash flowing and the loan is current."