Question

in what ways is a cmbs structure different from a cmo backed by residential mortgages? why is default risk in a cmbs offering given more attention?

Answer 1

A CMBS is vulnerable to default risk since no governmental organizations, unlike in the case of a CMO backed by residential mortgages, guarantee the payments or insure the mortgages against default. The CMBS's lowest rated tranches bear the majority of the default risk. Prepayment risk is not a major problem for CMBS because prepayment penalties and "lockout" clauses are frequently included with commercial mortgages.

What is Prepayment?

⇒ Prepayment is the early, partial or complete repayment of a loan by the borrower, frequently as a result of an optional refinance to benefit from cheaper interest rates.

Prepayment is viewed as a financial risk in the context of a mortgage-backed security (MBS), also referred to as "call risk," because mortgage loans are frequently paid off early in order to receive lower interest rates through more affordable refinancing. In each of these scenarios, the payments that would have been provided to the MBS investor would have been higher than current market rates. The new financing may be less expensive because the borrower's credit has improved or because market interest rates have declined.

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