Rating agencies have been sounding alarm bells over aggressive underwriting in commercial mortgage-backed securities for more than a year, but until recently the worry has centered on the increased risk. Now, a new report shows that the volume of loan delinquencies is measurably on the rise.

The volume of delinquent CMBS loans outstanding climbed to $1.65 billion in the second quarter of 2007, up 12.7% from $1.46 billion in the first quarter, according to Standard & Poor's.

The rating agency attributed the spike to a weak retail property sector and to a delinquency increase among loans issued in 2006. The volume of delinquencies for that particular vintage of CMBS loans shot up 172% to $190.2 million in the second quarter from $69.8 million in the first quarter.

Of the nearly $165 billion in CMBS loans issued in 2006, 0.12% were delinquent at mid-year, which is twice the delinquency rate that the 2003 vintage of loans exhibited six months into 2004, S&P analysts found.

A debate has ensued in the industry about whether the S&P report is an accurate reflection of market conditions. For starters, there is no industry standard for measuring loan delinquencies, and analysts at other agencies say it is too early to judge whether delinquent loans are a worsening problem. “Until a vintage has had at least two years of seasoning, it's hard to tell if something is a trend or just idiosyncratic,” says Tad Philipp, managing director in the commercial mortgage finance group at Moody's Investors Service.

Investors can't accurately compare findings from one agency with those of another due to differences in the deals studied, and in definitions.

For example, Fitch Ratings doesn't consider a loan delinquent until the borrower is 60 days behind on payments, while S&P considers a loan delinquent once it becomes 30 days past due.

Those differences may explain why Fitch's U.S. CMBS delinquency index fell for the fifth straight month in June to 0.29%, two basis points lower than May's rate of 0.31%. “We haven't really seen the evidence of more defaults; our delinquencies have been slowing down,” says Mary MacNeill, managing director of the CMBS group at Fitch.

For investors, it's not clear which property sectors are most at risk, either. In the S&P study, retail delinquencies mushroomed to $262 million in the second quarter, up 22% from $214 million in the first quarter for all CMBS loans outstanding. S&P attributes the spike to declining fundamentals. Nationally, the retail vacancy rate climbed 10 basis points to 7.3% in the second quarter over the previous quarter, while rent growth slowed to 0.8% from 0.9% in the same period.

A recent default study by Fitch singles out the multifamily sector as the leading source of CMBS delinquency, accounting for 33% of all newly defaulted loans in 2006 and 48% of the previous year's default total. Meanwhile, the office sector accounted for 23% of the default total in 2006, followed by retail at 19%.

Fitch, S&P and Moody's Investors Service all expect CMBS delinquencies to rise as a result of aggressive underwriting in recently issued loans.

That's why Moody's in April boosted CMBS subordination levels in its ratings, requiring CMBS issuers to pay higher yields to bond holders at every level of the CMBS capital stack to compensate for heightened risk.

“We do agree that late 2006 and early 2007 was a low watermark for underwriting, and we expect those vintages to have higher delinquencies,” says Philipp, the Moody's researcher.

Even by S&P's calculation, the delinquency rate remains low, rising just one basis point to 0.28% in the second quarter. The real risk lies ahead, should the early rise in the delinquencies the agency detected in recent CMBS loans accelerate.