CMBS Fusion Transactions: A Tradeoff between Credit Quality and Diversity

Abstract

In recent years, fusion transactions have become the dominant structure in CMBS. Simultaneously, credit support has also come down materially. We find that part of the decrease can be attributed to the benefits of experience and the improving property type mix. However, the biggest factor contributing to the declining credit support is the inclusion of large investment-grade quality loans. These large loans reduce the total expected loss to the trust, but could also weaken the degree of diversification. To quantify the tradeoff between diversity and credit quality, we use Monte Carlo simulations to analyze the impact across the capital structure. Our key findings are: • Improvement in credit quality benefits all classes. • Diversification affects different parts of the capital structure differently; it helps the senior-most classes but could hurt equity holders. • Though fusion transactions are less diverse, due to the presence of high quality large-loans, diversification benefits can be achieved through a relatively small number of large loans - typically less than 10. • The resulting tradeoff for fusion transactions is that the improvement in credit quality often outweighs the reduction in diversity. • A fusion transaction with S to 10 investment-grade large loans can effectively lower the required credit support relative to a pure conduit deal despite the reduced diversity.