Fitch Updates U.S. CREL CDO Surveillance Criteria

Credit fundamentals continue to decline for collateral within U.S. commercial real estate loan collateralized debt obligations (CREL CDOs), according to Fitch Ratings. In response, Fitch has updated its surveillance methodology for U.S. CREL CDOs.

Concurrently, Fitch has placed an additional $6.1 billion (41 classes from 18 transactions) on rating watch negative. As a result, Fitch's entire rated CREL CDO universe is on rating watch negative.

Fitch anticipates substantial rating actions across the capital structures of U.S. CREL CDOs after applying its new surveillance criteria. Few tranches will receive ratings higher than BBB, with a majority of classes expected to be assigned below investment-grade ratings.

The Fitch CREL CDO Delinquency Index reached 8.7% in September, with delinquencies in individual CDOs ranging from 0% to 35%. Further, the CREL CDO Delinquency Index understates the full extent of underperforming loans in CREL CDOs by excluding realized losses, as well as extensions and modifications on high risk loans, Fitch says.

Fitch has increasingly observed asset managers removing credit-impaired assets at prices below par, resulting in realized losses to the portfolios. To date, aggregate losses to CDO collateral are estimated at $825 million, or 3.4% of initial fully ramped collateral. The cumulative delinquency rate for CREL CDOs is likely to exceed 15% by year-end when realized losses are considered.

Delinquencies have been and are expected to be tempered as asset managers continue to extend and modify many assets. Asset managers have extended, on average, 70% of loans maturing since January.

Additionally, while managers are realizing losses by trading out impaired assets, Fitch says they are often reinvesting in discounted assets with the full notional amount counted as par. Known as "par-building," these trades generally result in a net increase to the notional collateral balance.

The effect of par-building may be to reduce the significance of overcollateralization tests by allowing the tests to remain compliant. Although par-building is typically permitted under transaction documents, Fitch may increase its expected loss on new purchases to reflect, at a minimum, the difference between par and the purchase price.

Preliminary application of Fitch's updated criteria results in an average CREL CDO loss expectation of 35%, ranging from less than 20% to more than 60%. The broad range of loss expectations reflects the unique characteristics of each portfolio.

For example, the lower expected losses reflect portfolios with lower leveraged, less transitional assets, while higher expected losses typically reflect portfolios with transitional, deeply subordinated collateral.

To derive the base-case expected losses for each transaction, Fitch's analysis included a prospective cashflow decline for each loan, which averages 15%. The corresponding value declines range from 35% to 60%.

SOURCE: Fitch Ratings

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