The share of interest-only loans in U.S. conduit commercial mortgage-backed securities pools rose to the highest level since 2007 in a sign that credit quality is deteriorating, Moody's Investors Service said.
Moody's called the rising inclusion of interest-only loans in conduit CMBS pools, to levels comparable to those in the pre-crash years of 2006 and 2007, "a significant negative credit trend and an important warning sign of deteriorating underwriting standards."
Conduit CMBS deals contain multiple loans bundled together into bonds. The share of interest-only loans in conduit pools rose to 76.4% in the first quarter, after a steady climb that began in 2010, following a period in which CMBS issuance was largely dormant in the wake of the global financial crisis. The share of interest-only loans last passed the 75% threshold in late 2006, Moody's said. Moreover, the agency said, almost half of all conduit pools have full-term interest-only loans, a level last reached in the first quarter of 2007.
Leverage, according to the Moody's loan-to-value metric, remained high at 117.3% in the first quarter, similar to the average loan-to-value ratio in 2007 CMBS transactions. The metric has held steady in the same range since roughly early 2015.
Moody's said that when all other factors are equal, interest-only loans, in which borrowers are not required to pay back the principal amount they owe until the end of the term, tend to have higher default rates — especially when interest rates are rising over the long term — and greater loss severity. Their rising popularity is "an important bellwether" of CMBS credit quality, the agency said.
While loan originators typically take steps to mitigate the risk of interest-only loans, such as lending at lower leverage, favoring higher-quality properties and using partial-term rather than full-term interest-only periods, those steps have not eliminated the higher risk of interest-only loans' greater prevalence, Moody's said. In a highly competitive lending environment, the vast majority of borrowers with high-quality properties, especially in central business districts, have been able to negotiate full-term interest-only loans, Moody's said.
Moody's said lower-quality properties typically receive partial-term rather than full-term interest-only loans, but noted that in new transactions, 40% of full-term interest-only loans and 77% of partial-term interest-only loans are backed by low- to medium-quality suburban properties.
