Page 83 - FINAL CFA SLIDES DECEMBER 2018 DAY 14

Session Unit 15:
53. Introduction To Asset-Backed Securities

The basic CMBS structure is created to meet the risk and return needs of the CMBS investor. As with
residential MBS securities, rating agencies assess the credit risk of each CMBS issue and determine

the appropriate credit rating. Each CMBS is segregated into tranches. Losses due to default are first
absorbed by the tranche with the lowest priority. Sometimes this most-junior tranche is not rated
and is then referred to as the equity tranche, residual tranche, or first-loss tranche.

As with any fixed-rate security, call protection is valuable to the bondholder. In the case of MBS, call
protection is equivalent to prepayment protection (i.e., restrictions on the early return of principal
tanties
through prepayments). CMBS provide call protection in two ways:
• loan-level call protection provided by the terms of the individual mortgages, and
• call protection provided by the CMBS structure.

There are several means of creating loan-level call protection:

• Prepayment lockout. For a specific period of time (typically 2-5 years), the borrower is

prohibited from prepaying the mortgage loan.

• Defeasance. Should the borrower insist on making principal payments on the mortgage loan, the

mortgage loan can be defeased. This is accomplished by using the prepaid principal to purchase a
portfolio of government securities that is sufficient to make the remaining required payments on

the CMBS. Given the high credit quality of government securities, defeased loans increase the
credit quality of a CMBS loan pool.