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Rate Cut Adds More Worry for European CMBS
Asset Securitization Report--SourceMedia (January 19, 2009)
The Bank of England made its move to cut the U.K. base rate by half a point to 1.5%.
The move takes the benchmark interest rate to the lowest level since the Bank's founding in 1694 and follows the rest of Europe. While the cuts might work toward easing the credit crunch, they are likely to cause more problems on the embattled CMBS front.
Fitch Ratings analysts said that falling interest rates in Europe might increase effective deal leverage in CMBS deal swap valuations. To avoid the associated swap breakage costs, servicers may be deterred from taking swift remedial action on impaired loans.
"This will especially compound the concerns of senior investors, many of whom are less than pleased at what they consider to be the intransigence in loan resolution," said Euan Gatfield, senior director in Fitch's CMBS team. "At the same time, it adds another dimension to the challenge of servicing European CMBS in the present climate."
Gatfield added that property-owning borrowers and lenders should agree upon fixed interest outgoings, as is the case in the U.S. where it is the norm for stabilized income-producing properties to be financed with fixed-rate loans that cannot be prepaid. Any borrower seeking to sell a property is obliged to replace it with adequate risk-free security.
In Europe, this type of call protection does not apply, and borrowers are entitled to prepay their loans, which introduces the problem of negative convexity where fixed-rate lenders face greater prepayment risk just as interest rates fall and more competitive loans enter the market. This is precisely the scenario now being experienced in Europe.
"Further delays in responding to evidence of loan impairment will undoubtedly frustrate many investors, certainly those who fear that by prolonging exposure to the real estate market, savings made on swap breakage costs will be outweighed by property value declines." said Andrew Currie, managing director of Fitch's CMBS team. "That being said, an element of caution would be understandable among servicers left the thankless task of forecasting which of these risks will prove the greater."
To avoid negative convexity, European CMBS are structured with floating-rate bonds and the interest rate mismatch caused by fixed rental income being financed by variable rate CMBS is hedged, typically using swaps contracted either by the borrower or the issuer. This, however, only transfers negative convexity from a lender to the swap counterparty.
"If the swap is not to be entered into at an above-market rate, such asymmetry will need to be offset, which is accomplished by requiring borrowers to provide an indemnity for any positive value of the terminating swap contract to the counterparty at the time a loan is prepaid," Gatfield said. "Consequently, a degree of call protection is, in effect, embedded in loans that underlie European CMBS."
However, this solution breaks down when prepayment is triggered by loan acceleration, and can cause bond recovery proceeds to diminish.
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