Fitch Downgrades RFC CDO 2006-1; Revises Outlooks & Assigns LS Ratings

RFC 2006-1 is collateralized by both senior and subordinate commercial real estate (CRE) debt, with 51.6% whole loans/A-notes, 12.8% B-notes, and 17.6% mezzanine loans. Fitch expects significant losses upon default for the subordinate positions since they are generally highly leveraged, thin debt classes. Further, the portfolio currently contains 9.4% defaulted or delinquent assets. A mezzanine loan secured by an interest in a construction project (3.4%) is defaulted and expected to be a complete loss, while a multifamily whole loan (6%) is delinquent on interest payments. An additional four assets (19.1%) are considered Fitch Loans Of Concern; two are whole loans, and two are mezzanine loans.

Beginning in the first quarter of 2009, each of the class C, D, E, F, and G overcollateralization (OC) tests breached their respective covenants. As a result, classes D and below are no longer receiving any proceeds as of the October 2009 trustee report. All excess interest proceeds (after class C) and any principal proceeds are currently being redirected to redeem the class A-1 notes. As a result, class A-1 has paid down by over $60 million to date. Given its expectations of further defaults, Fitch considers it unlikely that classes below the D, E, F, and G OC tests will receive any further proceeds over the life of the transaction. Fitch believes it may be possible for the class C test to cure, at least temporarily, as the senior notes continue to de-lever and as the hedge notional reduces. Payments to the hedge counterparty are currently the single largest transaction expense.

RFC 2006-1 was issued as a $600 million CRE collateralized debt obligation (CDO) managed by Realty Finance Corporation. The transaction has a five-year reinvestment period that will end in March 2011. As of the October 2009 trustee report and per Fitch categorizations, the CDO is substantially invested as follows: office (31.8%), hotel (23.8%), CMBS (18%), multifamily (13.7%), industrial (7.1%), construction (3.4%), and other (2.2%). Fitch is generally concerned with the relatively high concentration of hotel properties in the portfolio, as these have proven to be more volatile assets. While the hotels securing the assets in this portfolio are typically full-service trophy properties, all but one of the loans are subordinated positions.

Under Fitch's updated methodology, approximately 53.3% of the portfolio is modeled to default in the base case stress scenario, defined as the 'B' stress. In this scenario, the modeled average cash flow decline is 14% from either year end 2008 or more recently reported cash flows. Fitch estimates that recoveries will average 34.8%.

The largest component of Fitch's base case loss expectation is a mezzanine loan (4.7%) secured by an interest in a 1,340 room full service hotel located in Honolulu, Hawaii. The loan is highly leveraged and as of April 2009 has experienced a 28% cash flow decline from the prior year. While it is likely the loan will continue to receive interest payments during the loan term, Fitch expects this asset to experience a complete loss at maturity in its modeling.

The next largest component of Fitch's base case loss expectation is a whole loan (6.6%) secured by a 72-room boutique hotel located in the Times Square area of New York City. While the property has been able to maintain occupancy at above 60%, room revenues as of April 2009 were down over 40% from the prior year, and net operating income decreased by nearly 90%. The lenders modified the loan terms in order to relieve some of the immediate pressures due to debt service payments; however, the severe cash flow decline presents a high risk of default.

The third largest component of Fitch's base case loss expectation is a whole loan (6%) secured by a 324-unit multifamily property located in Phoenix, Arizona. The property is currently delinquent as performance declined steadily due to the general market conditions in the Phoenix area, where apartment inventories have grown in part due to failed condo projects being re-apartmented. Management at this property has been offering significant concessions in attempts to maintain occupancy.

This transaction was analyzed according to the 'U.S. CREL CDO Surveillance Criteria,' which applies stresses to property cash flows and DSCR tests to project future default levels for the underlying portfolio. Recoveries are based on stressed cash flows and Fitch's long-term capitalization rates. The default levels were then compared to the breakeven levels generated by Fitch's cash flow model of the CDO under the various default timing and interest rate stress scenarios, as described in the report 'Global Criteria for Cash Flow Analysis in CDOs'. Based on this analysis, the class A-1 notes' breakeven rates are generally consistent with the 'BB' rating category; and the class A-2 and class B notes' breakeven rates are generally consistent with the 'B' rating category.

Ratings for classes C through K are generally based on a deterministic analysis, which considers the current percentage of defaulted and delinquent assets and any Fitch Loans of Concern, as well as the likelihood for OC tests to fail and/or cure. Based on this analysis, class C is consistent with a 'CCC' rating, meaning default is possible given the credit enhancement to each class falls below Fitch's base case loss expectation of 34.8%. Classes D through F are rated 'CC', meaning default is probable, and classes G through K are rated 'C', meaning default is deemed inevitable.

The class A-1 through B notes were each assigned a Negative Rating Outlook reflecting Fitch's expectation of further negative credit migration of the underlying collateral. These classes were also assigned Loss Severity (LS) ratings ranging from 'LS3' to 'LS5'. The LS ratings indicate each tranche's potential loss severity given default, as evidenced by the ratio of tranche size to the expected loss for the collateral under the 'B' stress. LS ratings should always be considered in conjunction with probability of default indicated by a class' long-term credit rating. Fitch does not assign Rating Outlooks or LS ratings to classes rated 'CCC' or lower.

Classes C and K were assigned recovery ratings (RRs) to provide a forward-looking estimate of recoveries on currently distressed or defaulted structured finance securities. The recovery ratings are calculated using Fitch's cash flow model, and incorporate Fitch's current 'B' stress expectation for default and recovery rates (53.3% and 34.8%, respectively), the 'B' stress USD LIBOR up stress, and a 24-month recovery lag to determine the present value of all future proceeds to that class. All modeled distributions are discounted at 10% to arrive at a present value and compared to the class' tranche size to determine a recovery rating. The assumptions for the 'B' stress USD LIBOR up stress scenario are found in the report, 'Fitch USD LIBOR Stresses' (Jul. 31, 2009), available on Fitch's web site at 'www.fitchratings.com'.

The assignment of 'RR5' to class C reflects modeled recoveries of 27.5% of its outstanding balance. The expected recovery proceeds are broken down as follows:

--Present value of expected principal recoveries ($1.2 million);

--Present value of expected interest payments ($2.9 million);

--Total present value of recoveries ($4.1 million);

--Sum of undiscounted recoveries ($8.3 million).

The assignment of 'RR6' to classes D through K reflects that the modeled recovery for each class is less than 10% of its principal balance.

Fitch has affirmed and assigned LS ratings and a Rating Outlook to the following class:

-$34,500,000 class B at 'B/LS5'; Outlook Negative.

Fitch has downgraded, assigned LS and RR ratings, and assigned Rating Outlooks to the remaining classes as follows:

-$311,173,996 class A-1 to 'BB/LS3' from 'AA'; Outlook Negative;

-$33,000,000 class A-2 to 'B/LS5' from 'A'; Outlook Negative;

-$15,000,000 class C to 'CCC/RR5' from 'B';

-$13,500,000 class D to 'CC/RR6' from 'B';

-$9,000,000 class E to 'CC/RR6' from 'B';

-$10,500,000 class F to 'CC/RR6' from 'B';

-$13,500,000 class G to 'C/RR6' from 'CCC';

-$4,500,000 class H to 'C/RR6' from 'CCC';

-$24,000,000 class J to 'C/RR6' from 'CCC';

-$20,250,000 class K to 'C/RR6' from 'CCC'.

Additionally, all classes are removed from Rating Watch Negative.

These rating actions reflect the application of Fitch's current criteria which are available at 'www.fitchratings.com' and specifically include the following reports:

--'Global Structured Finance Rating Criteria' (Sept. 30, 2009);

--'U.S. CREL CDO Surveillance Criteria' (Nov. 9, 2009);

--'Criteria for Structured Finance Loss Severity Ratings' (Feb. 17, 2009);

--'Criteria for Structure Finance Recovery Ratings' (Aug. 17, 2009);

--'Global Criteria for Cash Flow Analysis in CDOs' (Nov. 9, 2009).

Additional information is available at 'www.fitchratings.com'.

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