Credit Risk and Subordination Levels in Commercial Mortgage-Backed Securities (CMBS)

Abstract

Subordination is designed to provide credit risk protection for senior commercial mortgage-backed securities (CMBS) tranches by allocating the initial credit losses to the more junior tranches. Subordination level should in theory reflect the underlying credit risk of the CMBS pool. In this paper, we test the hypothesis that subordination is purely about credit risk as intended. We find a very weak relation between subordination levels and both the ex post and ex ante measures of credit risk, rejecting our null-hypothesis. Alternatively, we find that subordination levels were driven by non-credit risk factors, including supply and demand factors, deal complexity, issuer incentive and a general time trend. We conclude that, contrary to the traditional view, subordination level is not just a function of credit risk. Instead, it also reflects the market need of a certain deal structure and is influenced by the balance of power among issuers, credit rating agencies (CRAs) and investors.