Subordination class by class, how sequential paydown builds it and realised losses erode it, and what it means in pool defaults.
A CMBS class's credit enhancement is the total balance of every class junior to it, divided by the balance of the loan pool. In an illustrative $1,000M conduit, Class D has $75.0M of bonds beneath it, so its credit enhancement is 7.50 per cent: the pool can lose 7.50 per cent of its principal before D loses a dollar. It is not a fixed number. Sequential paydown raises it and realised losses cut it.
Worked in full in CMBS and CRE CLOs by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An investor is looking at a conduit CMBS backed by $1,000M of fixed-rate commercial mortgages, with eight principal classes paid sequentially and losses allocated from the bottom up. The prospectus prints credit support at issue; the investor wants to rebuild it and see how it moves. The structure is simplified and illustrative: no interest-only classes, no reserve, one senior class rather than several time-tranched ones.
Start at the bottom of the stack and add up. Class G, the first-loss class, has nothing beneath it. Class F has G's $30.0M. Each class's enhancement is the running total below it over the pool.
CEclass = Σ balances of all junior classes / pool balance
Class D: (25.0 + 20.0 + 30.0) / 1,000 = 75.0 / 1,000 = 7.50%
Excel, with balances in B2:B9 from senior to junior: =SUM(B3:B$9)/SUM(B$2:B$9) in row 2, filled down to row 8 (Class G has nothing beneath it)
| Class | Balance | Junior classes | Credit enhancement | Detachment |
|---|---|---|---|---|
| A | 700.0 | 300.0 | 30.00% | 100.00% |
| A-S | 87.5 | 212.5 | 21.25% | 30.00% |
| B | 45.0 | 167.5 | 16.75% | 21.25% |
| C | 40.0 | 127.5 | 12.75% | 16.75% |
| D | 52.5 | 75.0 | 7.50% | 12.75% |
| E | 25.0 | 50.0 | 5.00% | 7.50% |
| F | 20.0 | 30.0 | 3.00% | 5.00% |
| G | 30.0 | 0.0 | 0.00% | 3.00% |
Credit enhancement is the class's attachment point; enhancement plus the class's own thickness is its detachment point. D attaches at 7.50 and detaches at 12.75: it absorbs the 5.25 points of pool loss between them.
Enhancement is measured in losses, but investors think in defaults. Divide by the loss severity. At a 40 per cent severity, D's 7.50 per cent is consumed only when loans totalling 18.75 per cent of the pool default; Class A's 30.00 per cent needs 75.00 per cent of the pool to default.
| Loss severity | Class D | Class A |
|---|---|---|
| 30% | 25.00% | 100.00% |
| 40% | 18.75% | 75.00% |
| 50% | 15.00% | 60.00% |
Severity is the assumption that carries the answer, and realised severities have a habit of exceeding appraisal-based ones, as why realised loss severity is higher than appraisal severity shows. A ten-point error in severity moves D's default tolerance by several points of the pool.
Sequential paydown. Amortisation, maturities and recoveries go to Class A first. After $200.0M of principal has retired A to $500.0M, the pool is $800.0M and every junior balance is unchanged, so every class's enhancement rises: A to 37.50 per cent, D to 9.38 per cent.
Realised losses. Now $40.0M is written off on liquidated loans (their recoveries, which pay down A, are left out to isolate the effect). Losses are allocated from the bottom: G's $30.0M is wiped out and F is cut to $10.0M. The pool is $760.0M.
| Class | At issue | After $200.0M paydown | After $40.0M losses | Losses, no paydown |
|---|---|---|---|---|
| A | 30.00% | 37.50% | 34.21% | 27.08% |
| A-S | 21.25% | 26.56% | 22.70% | 17.97% |
| B | 16.75% | 20.94% | 16.78% | 13.28% |
| C | 12.75% | 15.94% | 11.51% | 9.11% |
| D | 7.50% | 9.38% | 4.61% | 3.65% |
| E | 5.00% | 6.25% | 1.32% | 1.04% |
The paydown masks the damage. Against issue, Class A looks better off after the losses (34.21 against 30.00 per cent), while D has lost almost 40 per cent of its cushion, from 7.50 to 4.61. The last column shows the same losses arriving before any paydown, the worse case for every class: D is left with 3.65 per cent. Deals whose losses come early, before amortisation has built up the senior cushion, are the ones in which mezzanine bonds get hurt.
Many conduits switch from sequential to pro rata payment among the senior classes once the junior classes are written down, and some allocate principal pro rata from the start. Read the waterfall before assuming enhancement can only grow.
The common mistake is including the class itself in its own enhancement: D's balance plus everything below it is 12.75 per cent, which is its detachment point, not its protection. The second is reading enhancement at issue off the prospectus years later. It has to be recomputed from current balances, net of any appraisal reductions that are about to become losses. A CRE CLO adds an overcollateralisation test on top of subordination, worked in how the overcollateralisation test is calculated in a CRE CLO.
The book builds a whole conduit from a twenty-loan tape and a fourteen-class stack, with credit support computed rather than typed in, and the free workbook for this case runs its reverse-sequential loss allocation and stress scenarios.
In a conduit CMBS with no reserve fund or overcollateralisation, they are the same thing: the junior classes are the only enhancement. In this example Class A is supported by $300.0M of junior bonds on a $1,000M pool, 30.00 per cent. Structures with excess spread, reserve accounts or overcollateralisation, as in a CRE CLO, add enhancement beyond subordination.
Sequential principal payments retire the senior class first, so the junior classes become a larger share of a smaller pool and enhancement rises. Realised losses written off the bottom do the opposite. Here $200.0M of paydown takes Class D from 7.50 to 9.38 per cent; $40.0M of losses then takes it to 4.61 per cent.
Divide its credit enhancement by the assumed loss severity. Class D's 7.50 per cent at issue absorbs losses from defaults on 18.75 per cent of the pool at a 40 per cent severity, 25.00 per cent at 30 per cent severity and 15.00 per cent at 50. Class A's 30.00 per cent absorbs 75.00 per cent at a 40 per cent severity.
This article is one calculation from CMBS and CRE CLOs. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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