PRUDENTIAL FIXED INCOME

High Quality CMBS: The Value of Structure

Gary Horbacz, CFA
Principal, Structured Product
Research Team
Prudential Fixed Income

July 2010

Commercial mortgage-backed securities (CMBS) are an important yet

often misunderstood segment of the US fixed income market. Didnt the
commercial real estate bubble contribute to the 2007-2008 credit crisis?
Arent these securities really risky? This paper provides a brief history of
commercial mortgage-backed securities, explains in detail how they are
structured, and shows why we believe certain types of commercial
mortgage-backed securities can be especially attractive in fixed income
portfolios today.
The CMBS Market: Born From the Savings and Loan Crisis
Before the 1980s, commercial real estate was financed almost exclusively by
banks and insurance companies. Commercial real estate developers in need of a
mortgage would apply for one, and after careful underwriting and due diligence,
the bank or insurance company would issue the mortgage to the developer. The
mortgage a commercial real estate mortgage would remain on the books of the
bank or insurance company until it was paid off. This was good business at the
time. In fact, commercial real estate lending was a prized revenue source for many
banks in the late 1970s.
The economic recession of the early 1990s changed all that, leading to a collapse
in real estate prices and putting severe pressure on the existing commercial
mortgage loans sitting on the books of the banks and insurance companies. This
backlog of underwater mortgage loans, while certainly not the only reason, was
one of the key factors that triggered the Savings and Loan (S&L) crisis.
Following the crisis, banks and insurance companies sought to reduce the amount
of commercial real estate loans on their books.

Structured
Product
Perspectives
For more information contact:
Miguel Thames
Prudential Investment Management
2 Gateway Center, 4th Floor
Newark, NJ 07102-5096
973.367.9203
miguel.thames@prudential.com

As always seems to be the case, the eclipse of one source of funds invariably led
to the birth of another. And so from the S&L crisis emerged a new source of
financing for commercial real estate activity: the commercial mortgage-backed
securities market. A mortgage lender could now assemble a pool of the
commercial mortgage-backed loans it had made and sell the entire package of
loans to an intermediary, typically a trust or a special purpose vehicle (SPV). That
entity, in turn, would securitize them. To do so, the SPV would divide up the
pool of mortgage loans it had purchased into a range of different buckets based
on perceived credit risk, maturity, and other characteristics, and would then issue
different securities for each risk tier.

The Importance of the CMBS Securitization Process

This securitization process for the CMBS market, like the process for other structured product markets, served
three important purposes:
1) Provided a continuing stream of new capital to mortgage lenders. By removing the existing mortgage loans
from the books of lenders, it provided lenders with fresh capital to make new commercial mortgage loans,
stimulating the US economy.
2) Provided more investors with a new source of potential return. Formerly, only investors with significant
commercial real estate expertise were able to reasonably invest in commercial mortgage loans. Securitization
helped to bring commercial real estate finance into the mainstream, broadening the sectors appeal to a wider
range of investors and increasing liquidity in the sector dramatically.
3) Provided investors a new-found way to finely structure their risk. Because the securitization process
effectively placed the resulting commercial mortgage-backed securities into different risk tiers, it permitted
investors to purchase only the type and degree of risk they explicitly wanted to assume.
The efficiency with which the commercial real estate securitization market matched different investor appetites
with desired types of securities led to rapid growth soon after its birth. As Figure 1 below illustrates, issuance of
commercial mortgage-backed securities rose rapidly beginning in the late 1990s, reaching a record-high in 2007:
Figure 1
Commercial Mortgage-Backed Security Issuance
1990-2009
$ billions
250
200

CMBS Annual Volume

150
100
50
0

Source: Commercial Mortgage Alert. US issuance only. As of December 31, 2009.

Securitization Brought Change to the Commercial Mortgage Loan Market

The securitization process dramatically improved both liquidity and transparency in the commercial mortgage
loan market, both long-awaited and welcome developments. It also increased the demand for new commercial
mortgage loans to use as collateral for the securitizations. Many lenders, some of them newer entrants into the
commercial lending business, were eager to provide the required supply. Originating a commercial mortgage loan
and then selling it to a CMBS trust was a profitable venture for Wall Street and, unlike the traditional commercial
mortgage loans banks and insurance companies had been making, this new business required no retention of risk
on their part. Indeed, this dynamic caused a fundamental shift in the commercial mortgage market: the CMBS
securitization process meant that many new commercial mortgage loans were now being originated solely for the
purpose of securitization. In 2007, CMBS represented almost 45% of new commercial mortgage origination.
Securitized lenders began competing aggressively to make new commercial mortgage loans, and, not surprisingly,
underwriting standards began to deteriorate. Two key indicators of declining loan quality are seen in Figure 2 on
the left, below. The first is Debt Service Coverage Ratio, or DSCR, which is defined as a propertys income
divided by its debt service. Debt-service coverage ratios describe the amount of the propertys cash flow that is
available to meet interest and principal payments on the loan. Lower DSCRs indicate riskier loans.

The Loan-to-Value (LTV) ratio is the second key indicator of loan quality. The LTV ratio expresses the size of
the mortgage loan as a percentage of the value of the underlying property held as collateral. It is critically
important to valuing the underlying collateral within a CMBS trust. At time of issuance, loans in a typical CMBS
trust may have an average LTV ratio of 75% 1, with the ratios of individual loans ranging from 50% to perhaps
80%.
Note that Figure 2 below shows changes over time in Moody's stressed DSCRs and LTVs. Moody's computes
stressed DSCR using a constant loan coupon for all loans, thus putting the DSCR for loans originated under
different interest rate environments on an "apples-to-apples" basis. Likewise, Moody's assumes a constant
relationship between property value and property income when computing stressed LTVs. Moody's
normalization of DSCR and LTV permits easier identification of trends in the quality of loan underwriting across
different time periods by removing the effects of both the interest rate environment and the required returns that
happened to be in effect when a particular loan was originated. When these are removed, trends that otherwise
might not be apparent can be identified.
As shown in Figure 2, Moody's stressed DSCR fell precipitously from 2003 through 2007, while Moody's LTV
rose nearly 25% over the same period. These trends reflected two dynamics: rapidly rising commercial real estate
values relative to property income and more aggressive initial underwriting for new loans. Indeed, Figure 3 below
shows the sharp rise in riskier interest only loans2 during this time.
Figure 2
Loan Underwriting Standards
Declined Rapidly Beginning in 2005
Credit Trends of U.S. Conduit Securitizations
3Q2002 2Q2008

Moodys LTV
(RHS)

Moodys DSCR
(LHS)
1.25
1.20
1.15
1.10
1.05
1.00
0.95
0.90
0.85
0.80
0.75

Figure 3
Sharp Rise in Interest-Only Loans
As Underwriting Standards Deteriorated
2000-2007

Mdy's
DSCR
Moodys
DSCR
Moodys
LTV
Mdy's
LTV

Loans Requiring Both Interest and Principal Payments

Loans Permitting Some Periods of Interest-Only Payments
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

120%
110%
100%
90%
80%
70%
60%

Source: Moodys. As of March 31, 2008.

Source of data: Trepp.com.

These are conduit securitizations, comprised of diverse pools of underlying commercial mortgage loans. They are the most common
type of CMBS.

An average LTV ratio of 75% means that, on average, the outstanding balances on the mortgage loans equal 75% of the value of the
commercial properties within the trust: $75 million of loans on properties worth $100 million, for example.

These loans, as their name suggests, required only interest payments during the term of the loan, with a balloon payment at maturity.

Like All Bubbles, This One Also Burst

The development and growth of the securitization process created demand for new commercial mortgage loans,
and this demand, in turn, put upward pressure on commercial real estate prices. By mid-2007, though, the bubble
was showing signs of fatigue. As Figure 4 below shows, sales of commercial properties reached a lofty $70+
billion in the second quarter of 2007, but then began tumbling from there. From their peak in mid-2007 to trough
early this year, sales of commercial properties fell a stunning 89%. With sales plunging, prices of commercial real
estate properties followed suit, falling 44%, as seen in Figure 5 below:
Figure 5
Sharp Drop-off in Prices of Commercial Properties
Beginning in Mid-2007

Figure 4
Sharp Drop-off in Sales of Commercial Properties
Beginning in Mid-2007

$ billions
80
Industrial
70
Apartment
60
50
40
30
20
10
0

Retail
Office

Index Value
200
180

Peak to 1Q10: -89%

Commercial Property
Price Index

160
-44%

140
120

One Year: -23%

100
80

Source: Reis; US domestic arms-length transactions of $2 million

and greater. Used with permission.

Source: Moodys/REAL Commercial Property Price Indices, May 2010.

Not surprisingly, commercial mortgage loan delinquencies soared in response, from a low of 0.4% in early 2007
to a current high of 8.9%.
Figure 6
CMBS Loan Delinquencies
as % of CMBS Loans Outstanding
Fixed Rate CMBS Conduit Securitizations
April 2002 - June 2010
% 10
9
8
7
6
5
4
3
2
1
0

Delinquent Loans

8.9%

0.4%

Source: RBS, Barclays Capital, and Trepp. As of June 2010.

The Impact on the CMBS Market

With such turmoil throughout the commercial real estate market, it is not surprising that spreads of commercial
mortgage-backed securities ratcheted wider in response. The spreads of high quality, AAA-rated commercial
mortgage-backed securities hit a peak of swaps +1500 bps during the depths of the global credit crisis in
November 2008.
As it did with other sectors of the credit markets, the US Government intervened in early 2009 to try and stop the
decline of the commercial mortgage-backed securities market. Government-initiated programs such as the Term
Asset-Backed Securities Loan Facility (TALF) and the Public-Private Investment Program (PPIP) were designed
to improve liquidity and promote price transparency in the securitization markets and furnish new capital. These
efforts, along with an improving economic picture, helped spreads on commercial mortgage-backed securities
tighten substantially throughout 2009 and so far in 2010.
Despite this significant recovery, spreads on AAA-rated commercial mortgage backed securities are still wide
relative to investment grade corporate bonds and other securities:
Figure 7
CMBS Spreads Ratcheted Wider During Crisis and Then Rebounded Sharply,
But Remain at Attractive Levels
January 2007 - July 2010
Spread to LIBOR
1800
1600
1400
1200
1000
800
600
400
200
0

10 Yr Super Senior CMBS

Invest Grade Corp

375 bps
180 bps

Source: JPMorgan and Barclays Capital. As of July 21, 2010.

These relatively generous spreads, coupled with the unique structural characteristics of commercial mortgagebacked securities, make certain tranches of these securities highly attractive today. To understand why, lets first
understand the structures and features of such securitizations.

The Basic Features of a Commercial Mortgage-Backed Security

Commercial mortgage-backed securities are bonds backed by commercial mortgage loans. Loans on all
commercial property types are eligible as collateral, including loans for multi-unit apartment buildings, office
complexes, malls and other retail structures, industrial units such as bulk distribution and warehouse facilities,
hotels, healthcare facilities, and manufactured housing. Most geographic locations across the US are represented.
Collateral sizes range from small $1 million loans for a single property to massive multi-billion-dollar loans for
large-scale retail and office developments. The loans are generally structured with final maturities of five, seven,
or 10 years, with most loans having terms of 10 years. Commercial mortgage loans almost always have a large
balloon payment due at final maturity.

Once commercial mortgage loans are made, the mortgage originator groups the loans together into pools. Pools
generally contain between 100-300 loans, but pool characteristics can vary widely. Conduit securitizations are
loan pools that are typically diversified across loan size, with the ten largest loans comprising perhaps 30-40% of
the pool. Conduit deals are geographically diversified, but do tend to have higher exposure to the major economic
producing regions of the country (i.e., northern and southern California, Texas, and New York). The office, retail,
and multifamily property types typically represent 60-80% of each transaction, with the mix of each type varying
substantially from deal to deal and across vintages. The mix often depends upon the amount of new construction
of each property type along with the number of sales of existing properties.
The mortgage originator sells the pools to a Special Purpose Vehicle that will securitize them. A Special Purpose
Vehicle, or SPV, is a legal entity set up by a company, typically an investment bank or other financial institution,
for a specific purpose of issuing commercial mortgage-backed securities.
There are five key features of commercial mortgage-backed securitizations that are critical to understanding how
they work:
1) Multiple Tranches
A defining feature of all commercial mortgage-backed securitizations is that they are issued in different
tranches, with each tranche differing in payment priority, duration, and yield. The SPV hires an external rating
agency to assign credit ratings to each tranche.
Figure 8 below illustrates the tranche structure. As you can see, tranches range from AAA-rated all the way down
to unrated. Over the years, tranches have become highly segmented, with a number of variations even within a
given ratings tier. By 2005, while the rating agencies had become comfortable assigning AAA ratings to tranches
with only 12-15% credit enhancement, many investors in the CMBS market were not as enthusiastic. These
investors began demanding tranches with higher levels of credit enhancement. The CMBS market evolved
accordingly, to a practice of creating three basic classes of AAA-rated tranches within a commercial mortgagebacked securitization: super senior AAA tranches, a Mezzanine AAA tranche, often referred to as the AM
tranche, and a Junior AAA tranche, or AJ tranche. Each tranche carried a different risk and reward profile
because of its degree of credit enhancement and placement in payment priority within the overall securitization.
2) Varying Degrees of Credit Enhancement
SPVs issuing CMBS often provide credit enhancement to certain tranches of the securitization to improve their
credit quality and earn a higher rating from the external ratings agencies. The securitization illustrated in Figure 8
below includes:
a) A Super Senior AAA tranche as its highest and most creditworthy tranche. Super-senior tranches often
came with 30% credit enhancement, meaning that the tranches subordinate to it comprise 30% of the
securitization. The subordinated 30% is the first to absorb any losses that might occur from the underlying
loans.
b) Immediately below that, but still rated AAA at origination, was often a Mezzanine AAA tranche (also
referred to sometimes as the AM tranche). This tranche typically offers 20% credit enhancement, meaning
that 20% of the securitization is subordinated to this tranche and thus absorbs any losses that might occur
among the loans.
c) Below that, but again still rated AAA at origination, was often a Junior AAA tranche (also referred to as
the AJ tranche) with 12-15% credit enhancement.

3) A Waterfall Payment Structure

Another defining feature of commercial mortgage-backed securities is their sequential payment structure, also
known as the waterfall. The waterfall structure determines how payments are made and losses absorbed within
a securitization.
To best understand the waterfall structure, lets first review what happens when a commercial mortgage loan
defaults. After a default, the commercial property is foreclosed on by the servicer and typically sold. The net
proceeds from the foreclosure sale become the recovery proceeds of the loan. For example, if the remaining loan
balance was $1 million, and the foreclosed property sale netted $600,000, the trust would recognize a principal
recovery of $600,000 and a realized loss of $400,000. Said differently, the trust incurred a loss severity of
40% and a recovery rate of 60%.
Now lets see how this is applied to a commercial mortgage-backed securitization. Under the waterfall structure
illustrated below, if any of the underlying mortgage loans default and the recovery proceeds fall short of the
outstanding loan amount, the resulting realized losses are applied sequentially, in reverse order, starting at the
bottom and moving up. The unrated subordinate tranche is the first to absorb the loss, until that tranche is
completely written down. Losses then accrue upward to the B tranche, until it is completely written down, then to
the BB tranche, and so forth. The key point is that no super senior tranche can take even $1 of principal loss
until all subordinated tranches have been completely written down to zero. This would require realized
losses in excess of 30% of the outstanding loans.
The same process is applied, in reverse, for principal payments, including scheduled principal and loan
prepayments as well as, importantly, recoveries on defaulted loans. All principal payments received each month
are paid out to each tranche sequentially, starting from the top and moving down. Investors in the super-senior
AAA tranche are paid first until each investor is fully paid, then the mezzanine AAA class is paid, then the
junior AAA tranche is paid, and so on through the other subordinated tranches until all payments are exhausted.
Figure 8
Typical Commercial Mortgage-Backed Security Structure
Super Senior AAA

20.000%

AAA Mezzanine

10.125%
$2.5 Billion
Mortgage Pool

7.750%
4.500%
3.000%

Subordinated
Tranches

12.375%

2.125%
1.375%

Principal Paid From Top Down

30.000%

AAA Junior
AA
A
BBB
BB
B

Losses Accrued From Bottom Up

Subordination

Unrated

Source: JPMorgan. An Introduction to CMBS

April 2008

= Default x (1 Loss Severity Rate) = Principal Recovery

= Default x Loss Severity Rate = Principal Loss

4) Super-Senior Tranche Divided Further Into Time Tranches

The two remaining features of commercial mortgage-backed securitizations are perhaps the most interesting, in
that they provide investors a unique ability to identify and select precise risk exposures: time tranches and tranche
thickness.
When an SPV creates a commercial mortgage-backed securitization, it can assemble the tranches in any number
of ways. How the tranches are assembled how many there are and how large each tranche is -- depends on the
characteristics of the underlying collateral as well as investor preference and demand. We saw in Figure 8 that
most commercial mortgage-backed securitizations have a number of different AAA-rated tranches. In fact, most
commercial mortgage-backed securitizations then further segment the highest super senior tranche. As
illustrated in Figure 9 below, most super-senior tranches are further sub-divided into time tranches, typically
named A1 through A4:
Figure 9
Typical Commercial Mortgage-Backed Security Structure
Super-Senior Top Tranche Further Segmented By Time Tranches
Principal
Super Senior AAA

A1

A2

A3

A4

AAA Mezzanine
AAA Junior
AA
A
BBB
BB
B
Unrated
Source: JPMorgan. An Introduction to CMBS, April 2008.

The original size of the A1A4 time tranches are determined by the maturity schedule of the underlying loans in
the securitization. Generally, the A1 tranches are sized to reflect scheduled principal payments expected to occur
within three years. A2 tranches are sized to reflect scheduled principal payments expected to occur between three
and five years, A3 tranches are sized to reflect payments between five and seven years, and A4 tranches reflect
payments in eight or more years. We consider the A1 through A3 tranches as intermediate tranches and the A4
tranche as the last cash flow tranche.
Early time tranches are paid principal fully before any principal payments are made to the later time tranches. In
other words, all investors in the A1 tranche are paid fully before any investor in the A2 tranche is paid at all.
In this way, time tranches redistribute risk even more finely within the AAA-rated super-senior class of a
securitization. This notion of time tranches dramatically changes the risk-reward dynamic of investing in
commercial mortgage-backed securities for many investors. Indeed, it even permits investors with pessimistic
outlooks on commercial real estate to invest in the sector.
It is important to understand that this sequential payment priority among super-senior tranches will hold
as long as realized losses on the underlying loans do not exceed the 30% super-senior credit enhancement.
However, if realized losses ever exceed this level, then all future principal payments from that point

forward will be shared pro-rata between all remaining super-senior tranches. The importance of this
concept, referred to as the pro-rata trigger, will become even clearer after we understand tranche thickness.
5) Tranche Thickness
Each of the individual super-senior time tranches of a securitization could represent anywhere from 1% to 70% of
the entire securitization. This concept is known as tranche thickness and refers to the percentage of the total
securitization that a given tranche comprises. In Table 1 below, we show two different hypothetical
securitizations: one with thin intermediate super-senior tranches and the other with thick intermediate supersenior tranches.
Cumulative thickness refers to the size not only of a given tranche, but also includes all tranches that come
before it in payment priority. Because payments in a commercial mortgage-backed securitization accrue
sequentially, the cumulative thickness of your tranche in a securitization is an important determinant of whether
you will receive your full principal payments in a stress scenario.
There are important differences between cumulatively thin and cumulatively thick tranches. A cumulatively
thin tranche requires fewer principal payments or recoveries to be fully repaid, while a cumulatively thick
tranche requires more principal payments. In Deal A in the example below, the A3 tranche is cumulatively thin,
comprising only 13% of the overall securitization. The A3 tranche in Deal B, on the other hand, comprises 43%
of the securitization, and is thus considered a cumulatively thick tranche. In Deal A, only 13% of the loans
within the entire deal must repay in order for all investors in the tranche to be repaid fully. In Deal B, on the other
hand, fully 43% of the loans within the entire deal must repay for investors in the A3 tranche to be repaid fully.
For this reason, cumulatively thick tranches are not always the most desirable. In fact, the reverse is often true: the
thinner the tranche, the more defensive the security. Thin tranches require less principal repayment, either from
scheduled payments or recoveries on defaulted loans. The lower overall principal required to be repaid shortens
the timeframe needed for payment and lowers the likelihood of hitting the pro rata trigger prior to tranche
repayment.
Table 1
Investors Are Repaid Differently Depending on Whether a Tranche is Thick or Thin
Class
A1
A2
A3
A4
Subordinate

Deal A: Thin Tranches

Thickness
Cumulative
Thickness
3%
3%
7%
10%
3%
13%
57%
70%
30%
100%

Deal B: Thick Tranches

Thickness
Cumulative
Thickness
3%
3%
20%
23%
20%
43%
27%
70%
30%
100%

Source: Prudential Fixed Income. For illustrative purposes only.

How These Features Combine to Provide Protection to a CMBS Investor

Lets now look at an example that illustrates how all of these features within a securitization can provide fixed
income investors with a unique risk and reward opportunity. Table 2 below illustrates a hypothetical
securitization that includes $100 million of commercial mortgage loans. The SPV has structured this particular
securitization to include many different tranches, each a different size and with a different degree of credit
enhancement. The $70 million AAA-rated super-senior tranche is further subdivided into four different time
tranches.

Table 2
Hypothetical $100 Million CMBS Securitization
With The Super-Senior AAA-Rated Tranche Further Divided Into Four Time Tranches
Tranche Name

Super Senior AAA

$70 mm
Mezzanine AAA
Junior AAA
Other Subordinated

SubDivision
Tranches
A1
A2
A3
A4
Total
AM
AJ
B - NR

Tranche
Size
($mm)
$3
$7
$3
$57
$70
$10
$8
$12

Tranche
Credit
Enhancement
30%3
30%3
30%3
30%3
30%
20%4
12%4
0%4

Tranche
Tranche
Thickness1 Cumulative
Thickness2
3%
3%
7%
10%
3%
13%
57%
70%
70%
70%
10%
80%
8%
88%
12%
100%

Scenario
Principal
Loss
0%
0%
0%
70%
100%
100%
100%
100%

Source: Prudential Fixed Income. For illustrative purposes only. 1 Tranche Thickness = tranche size/total deal size. 2 Tranche Cumulative
Thickness = tranche thickness + thickness of all tranches paid before such tranche. 3 Tranche Credit Enhancement for super-senior AAA
= 30%. 4 Tranche Credit Enhancement for other tranches = 100% - cumulative thickness; represents the amount of realized loss on the
underlying loans as a percentage of the total pool that can be experienced before such class will take a loss.

Now lets assume a draconian scenario in which 100% of the loans default with a 70% loss severity. A 70% loss
severity means that the pool will suffer $70 million of losses and have $30 million of principal recoveries.
Understand that these assumptions are extremely pessimistic. To put them in perspective, the worst cumulative
commercial mortgage loan default rate ever experienced by any vintage was approximately 30%. Historical loss
severities have averaged 30%. The combination of a 30% default rate and a 30% loss severity produces realized
losses of 9%. The scenario we will discuss below produces 70% realized losses.
The last column in Table 2 above illustrates that even under these very extreme assumptions, the A1, A2, and A3
time tranches experience no loss. This seems counterintuitive, since the trust experienced 70% losses and these
tranches had only 30% subordination. The key is the recovery value of the defaulted loans. Although the trust
had 70% losses, it also had a 30% recovery rate on the defaulted loans. As the losses were applied to the
subordinate tranches, recovery proceeds were being paid to the super-senior tranches sequentially. In the example
above, recovery proceeds equaling 13% of the pool are received prior to the securitization reaching 30% realized
losses.1 Since the cumulative thickness of the A3 tranche is only 13%, the A3 tranche and the ones in front of it
(A1 and A2) are paid out in full before the losses pierce the 30% pro-rata trigger. The last cash flow A4 tranche is
left to absorb the remaining principal losses by itself: in our draconian scenario above, that tranche would incur a
70% loss.
This example demonstrates that if cumulative principal payments (scheduled principal payments as well as
recoveries from defaulted loans) as a percentage of the total pool meets or exceeds a particular tranches
cumulative thickness before realized losses exceed 30%, then that tranche will be repaid in full.
Cumulatively thin tranches in a securitization are highly likely to pay in full. Thats because even if defaults were
high enough to incur 30%+ realized losses in the overall securitization, thereby breaching the trigger level, those
defaults would generate at least some recoveries as they occur. These would be applied sequentially, starting with
the first time tranche. For this reason, time tranches in CMBS securitizations that are cumulatively thin can
withstand extreme realized loss scenarios in the underlying pool.

Since a constant 70% loss severity is assumed for all loans, the 30% pro rata trigger is hit after 43% of the underlying loans default (70%
loss severity x 43% defaulting loans = 30% loss). Since a 70% loss severity translates into a 30% recovery rate (recovery rate = 1 - loss
severity), then the same 43% defaulting loans produce 13% of recovery proceeds (30% recovery rate x 43% defaulting loans = 13% of
recovery proceeds).

10

Our View On the CMBS Market Today

At Prudential Fixed Income, we are quite positive on the defensive segments of the CMBS market. Our
preferences for individual securities are based upon our views of the quality of underwriting and the level of
commercial real estate prices at the time when the particular CMBS securitization was issued. Currently, our
favorite securities are:
Thin Intermediate Super Senior Tranches of Securitizations Issued Between 2006 and 2008
Given the top-of-the-market commercial real estate prices between 2006 and 2008, along with the very aggressive
underwriting practices that characterized loans originated during these "bubble years", we favor the most
defensive securities in these vintages. Cumulatively thin intermediate (A2-A3) super senior time tranches provide
substantial protection against a tail scenario, yet currently offer very attractive spread levels of swaps + 250 bps.
(As of July 22, 2010). While the last cash flow A4 tranches from these weaker securitizations offer even wider
spreads of approximately +350 bps, we believe they have a meaningful chance of loss in a stress scenario. In our
view, the extra +100 bps of spread does not compensate for this additional risk.
It should be noted that, given todays low rate environment, these securities are currently trading at premium
prices. ($101- $104 as of July 22, 2010.) This exposes these securities to a different risk: early repayment risk. In
a severe stress scenario, these premium-priced securities could repay at par sooner than anticipated, detracting
from total return. We rely on extensive loan level analysis to help mitigate this risk.
Last Cash Flow Tranches From Older Securitizations Issued Prior to the Second Half of 2006
We have a more positive expectation of loan performance for most securitizations issued prior to the second half
2006, given the more conservative underwriting practices and the lower commercial real estate prices at the time
of underwriting. For these older securitizations, we prefer the last cash flow super senior time tranche (A4).
These currently offer spreads over swaps of +165 bps for 2005 securitizations and +200 bps for early 2006
securitizations.
Have Not Yet Purchased Newer Securitizations Issued in 2009-2010
As noted earlier, the CMBS market is slowly recovering, with six new securitizations issued during the last
quarter of 2009 and so far into 2010. This new issuance can be characterized by generally fewer loans in each
deal and more stringent underwriting of each loan. Loan-to-value ratios are lower (healthier), with current LTVs
of 50-65% based upon today's property valuations, rather than 70-75% LTVs based upon what were peak market
commercial real estate prices back in 2007. Debt-service coverage ratios in the newer securitizations are based on
actual in-place (realized) cash flows rather than the pro-forma cash flows used at the peak of the market.
Despite these attractive attributes from a loan-level credit standpoint, we are currently not buying these new
CMBS securitizations. While the quality of the underlying loans has significantly improved, these securitizations
have less credit enhancement and less loan diversification. Furthermore, the AAA-rated last cash flow tranches
from these securitizations are currently offered at lower spreads of +150 bps over swaps. (As of July 22, 2010.)
We believe this spread concession to more seasoned deals is unwarranted, particularly given the structural
protections we can find in thin intermediate tranches of 2006-2008 securitizations or in last cash flow super
senior time tranches of 2005 securitizations.

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