“The fundamentals are slowly stabilizing,” Somerville says, noting that the key drivers are property cash flow, leverage, pool and portfolio attributes. “It is returning to an even keel,” he says, adding that large loans will still need to be worked out. “There are going to be more defaults going forward, so expect more defaults on loans in 2011 and going into 2012. Not to say that’s bad. Delinquency is starting slow.”

The report notes that proposed CRE CDOs with a wide mix of debt and CMBS bond CDOs with a low average rating are more likely to have their ratings capped at a notch or two above the average rating of the underlying assets. Fitch adds that “in spite of the diversity offered” by different debt types or multiple CMBS bonds, “the commonality of risks inherent” for these loans prevails in the overall credit evaluation. Weaker underlying assets, like lowly-rated, distressed or nonrated CMBS bonds and pools of highly leveraged B-notes or mezzanine loans, are unlikely to be rated by Fitch based upon the “inherent performance volatility of the assets,” the report says.

For future CMBS contributions, issuers may use the CDO funding platform to stabilize property performance. “If you have a floating rate loan, you could keep that vehicle moving by having loans paid off or getting new loans,” Somerville says. “It’s a good execution as far as the floating rate loan if the CMBS transaction monetizes fairly quickly over its life.”

The kitchen sink of CDOs, mixed debt--a mixture of B notes, mezzanine debt and other debt--is thrown off into cash flow, which is accumulated in a CDO and then redistributed according to the bonds that are sold. “I suspect that if someone holds a B note that was 20-cents on the dollar two years ago, it’s now worth 50-cents on the dollar,” Somerville says. “We are starting to see a recovery.”