In another sign of looser lending in commercial real estate, rating agencies have been demanding additional investor protections for what are known as the “junior” triple-A tranches of CMBS.
Junior triple-As were developed in the middle of the last decade as part of an effort to attract non-traditional investors to commercial mortgage-backeds. Instead of a single triple-A class of securities, banks started structuring deals with a senior tranche that had even more subordination than necessary to get a triple-A rating: the senior triple-A.
That left room to create a second, junior class of securities that still earned triple-A ratings, but were not quite as safe.
“Certain institutional investors wanted to have essentially bullet-proof triple-As,” said Max Marquardt, managing director at NewOak Capital, which provides due diligence, portfolio analysis and stress testing services.
Senior triple-As typically benefit from subordination of 30%, meaning that a transaction has to suffer a loss of 30% of its principal before those bonds get hit.
Initially, junior triple-As had credit support of 20%. Heading into the financial crisis, however, junior triple-As were structured with less and less credit support, as little as 12%, but still earned triple-As.
Concerns About Riskier Loan Collateral
This time around, rating agencies are being more careful, though none as careful as Moody’s Investors Service.
Concerned about weaker underwriting in 2014 and 2015 CMBS conduits, rating agencies are demanding increased levels of subordination for junior As. These risks have been well flagged in presale reports and credit research: conduits increasingly include loans that are highly leveraged; loans on properties encumbered by additional debt not included in trusts; and loans that pay only interest and no principal for either part or all of their terms.
All of these characteristics either increase the probability of default, the severity of default, or both.
For example, in a Jan. 29 report, Moody’s stated that the average loan-to-value (LTV) ratio for loans in CMBS conduits that it rated in the fourth quarter of 2014 increased to 113.6% from 112.2% in the third quarter.
The report also states that there has been further slippage in the first quarter of 2015, and that LTVs a “are poised to increase” above 120%.
Ultimately, increased support for the junior As benefits investors in the senior As as well. If the junior As were to sustain a loss, the senior As would be more at risk.
“There used to be a pretty significant cushion between the junior triple-A and senior triple-A, but now in our view the junior triple-A needs more enhancement, which has narrowed the cushion” said Tadd Phillipp, director of commercial real estate research at Moody’s.
Sometimes, however, increasing credit support for junior As is not enough to earn a top rating, at least from Moody’s. For example, Wells Fargo pegged the credit support on the junior A tranche of a March deal, WFCM 2015-LC10, at 26.6%. The tranche was rated triple-A by both DBRS and Morningstar, while Moody’s rated it one notch lower, at Aa1.’
The disconnect between the views of Moody’s and other credit rating agencies has been even wider. Credit Suisse’s C-SAIL 2015 CCRE22 for example, which also priced in March, issued junior As with 23% credit enhancement. That earned it a triple-A rating from Fitch, Kroll Bond Rating and Morningstar. However, Moody’s rated the note two notches lower, at Aa2’.
Philipp said that two years ago Moody’s began noticing that its ratings differed from those of other rating agencies on class D notes, which are typically at the lower end of the investment grade spectrum. Since then, “this disconnect started working its way higher up the capital structure.”
In its quarterly CMBS report, Moody’s stated that. for class D tranches on more recent deals, it would have recommended subordination levels of 11.5%.
At the average level of credit enhancement charged for fourth quarter 2014 conduit deals of 7.6%, “more than 70% of the class would be rated below investment grade, with a portion as low as B1’. ”
This disparity between Moody’s views and the views of its peers has led to some ratings shopping.
All of the CMBS conduits completed this year have dropped Moody’s from rating junior-level tranches. Phillipp said that the rating agency is already seeing some issuers forego a Moody’s rating on the senior portion of conduit deals.
Moody’s Monopoly’ on Credit Ratings
But dropping Moody’s altogether is not an option, since the investment guidelines of many money managers require CMBS to be rated by either S&P or Moody’s, and S&P has been banned by the U.S. Securities and Exchange Commission from rating conduit CMBS until Jan 21, 2016. (The ban, which S&P agreed to in January of this year, stems from ratings S&P issued in 2011 that the regulators say were misleading.)
Ken Cheng, managing director of CMBS at Morningstar, said that these investment guidelines explain why sponsor are doing deals with split-rated junior As, as opposed to dropping Moody’s entirely. “In the conduit space, with S&P out of the game for a year, there is a monopoly, in effect, on ratings,” he said.
“Moody’s is more of the outlier in terms of credit support levels,” Cheng said. “Historically [Morningstar] doesn’t really see support for such high levels of credit enhancement and we think that the levels that Morningstar has now, which are generally in the range of 23% to 25%, are reflective of the risk that is out there” and more than double the support levels seen in CMBS pre-crisis.
Still, the continued deterioration in commercial mortgage underwriting raises the question as to whether there will eventually be a change in the CMBS capital structure.
At some point, Morningstar and other rating agencies may either start to demand even more credit support for junior As or decide that they don’t warrant triple-A status.
“The problem with offering senior bonds with 35% or 40% subordination is that we question how many investors would actually be willing to pay up for the incremental increase in credit enhancement,” securitization analysts at Bank of America Merrill Lynch stated in a March 20 report.
Marquardt is not convinced that junior As will lose their overall standing as triple-A securities, however.
“Bankers will adjust their structure to make sure that it remains triple-A because that is the reason the [junior A] tranche exists,” he said.
B-Piece Buyers Flex Muscles
Rating agencies aren’t the only ones policing the credit quality of CMBS. Investors in the B tranches of deals, which assume the first losses, have a lot of say in the composition of deals, and have been known to veto individual loans that they are not comfortable with.
Cheng said there have already been some instances “at the B-piece level, where buyers are a lot more active in throwing out the really egregious underwriting.”
If this continues, he said, “then lenders with more aggressive underwriting may find their loans no longer going to conduits,”
Although it will ultimately be up to investors to push back on the aggressive underwriting, Cheng believes that it is “the job of credit rating agencies to give these weaker loans quite unfavorable treatment and perhaps they get kicked out eventually.”