Rating agencies are busy reviewing and downgrading existing commercial mortgage-backed securities issued between 2005 and 2007. The downgrades — which follow fallout primarily from the office, multifamily and retail sectors — are encouraging opportunity buyers still waiting for disaster to strike commercial real estate.

As these investors look for bargains among the anticipated wreckage of properties, notes, and securities, they are paying close attention to every report of a securitized loan going into default. While individual loans experiencing repayment difficulties have been a prime target, findings by Fitch Ratings suggest that asset managers seek to put a damper on expectations by bargain hunters.

Rescuing defaulted loans

In the most recent release of its Commercial Real Estate Loan Collateralized Debt Obligation Delinquency Index, Fitch concluded that delinquencies are leveling off. The rating agency observed a larger number of asset managers buying out credit-impaired assets (loans with repayment difficulties or reduced property values since the loans were issued) at prices below par. And even though the result has been realized losses to CDO collateral, many issuers have offset this deterioration through a process called "par building."

Par building was coined by the investment banking community to reflect removal of troubled loans from securitized pools, primarily through buying into troubled securities, at prices well below par value. This process has become the favored tool of asset managers.

Oftentimes asset managers are securities investors themselves, and can be working on behalf of current securities holders or investors seeking profits by strategically buying into troubled bonds. They can also represent opportunity investors who want access to the underlying real estate rather than a position in securities.

Fitch says that despite eight new delinquent loans entering its CDO delinquency index — loans that are 60 days or more delinquent — the May 2009 reading was relatively stable at 7.9%. That figure is up slightly from the April level of 7.8%. But the index keepers do not expect this trend to continue.

"Asset managers have been removing credit-impaired assets from CDOs, often in order to preserve overcollateralization ratio tests, which has tempered this month's delinquencies," says Karen Trebach, senior director for Fitch. The overcollateralization ratio tests are minimal collateral values or pledged assets that analysts use to assign or preserve a rating of underlying securities.

"However, Fitch anticipates that this reprieve will be short with delinquencies continuing to rise measurably through year's end, and more CDOs facing overcollateralization test failures in the coming months," Trebach concludes.

At center stage in this tug-of-war between first-loss investors and secured senior tranche owners are the asset managers, who seek to strike a balance that satisfies all parties. During the past two months they have been buying up tranches such as mezzanine and first-loss pieces, hoping to exercise their rights to cure these troubled securitized loans.

Discounted payoffs

The Fitch report points out that at least two asset managers reported accepting discounted payoffs on two loans, including a matured balloon loan. The securities issuer allowed the maturing balloon loan to be paid off at 56% of par.

In May, Fitch also reported that asset managers extended 33 loans, many of which were short-term extensions. Even though this trend is expected to be short-lived, no one can doubt the motivation of asset managers to preserve loans from reaching the point of a dreaded pileup in CMBS maturity defaults.

In fact, there are companies like Boston-based Investcap Advisors that provide opportunistic investors with listings of maturing CMBS loans.

"Investors are trying to get access to troubled loans early in the process, but that information is not readily available," says Scott Barrie, president of Investcap Advisors. "Our system of identifying these loans and passing the information on to investors gives them a solid base from which to either buy into some bond structures, or to take over troubled loans and assets at discounts."

Regardless of how investors access distress opportunities, the idea of discounted payoffs is catching. So as one group of asset managers pushes to resolve troubled securitized loans, another group is pulling for identifying and buying these troubled assets at a discounted payoff. And the tug-of-war continues.