What is Subordination About? Credit Risk and Subordination Levels in Commercial Mortgage-backed Securities (CMBS)

Subordination is designed to provide credit risk protection for senior 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, the 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, CRAs and investors. J Real Estate Finan Econ DOI 10.1007/s11146-014-9480-1 We are grateful to Peter DeMarzo, Michael Dewally, Mark Flannery, Sally Gordon, Dwight Jaffee, Tim Riddiough, Amit Seru, Walt Torous, Sean Wilkoff and participants at the 2007 RERI Research Conference, 2013 AREUEA Annual Meetings, the 2013 MFA Conference and the 2013 AREUEA International Conference for helpful comments. Special thanks are due to the Real Estate Research Institute (RERI) for its financial support. All remaining errors as well as the opinions expressed in this paper are our own responsibility. They do not represent the opinions of the Board of Governors of the Federal Reserve System or its staff. X. An (*) Department of Finance, San Diego State University, San Diego, USA e-mail: [email protected] Y. Deng Institute of Real Estate Studies, National University of Singapore, 21 Heng Mui Keng Terrace, #04-02, Singapore 119613, Singapore e-mail: [email protected] J. B. Nichols Board of Governors of the Federal Reserve, Washington, DC, USA e-mail: [email protected] A. B. Sanders School of Management, George Mason University, Virginia, USA e-mail: [email protected]