Commercial mortgage backed securities (CMBS) collateralized by floating rate loans (floaters) have become an important part of the CMBS market. Because they have low prepayment penalties and short lockout periods, floaters have generally appealed to borrowers with transitional assets or short-term holding horizons. However, based on their interest rate expectations, some conduit borrowers may opt for floaters as a flexible financing alternative that will provide them with the opportunity to refinance in a more favorable interest rate environment.
Moody's approach to rating floating rate CMBS transactions shares the same methodology as that used for fixed rate CMBS, except for an additional step necessary to assess the credit risk associated with floating interest rate. First, Moody's reviews the collateral performance and determines stabilized cash flows. A fixed rate-based baseline credit enhancement is derived using Moody's debt service coverage ratio (DSCR), loan-to-value (LTV) ratio and asset quality grade. In the next step, interest rates are stressed to determine the credit enhancement adjustment necessary to compensate for floating rate risk. This adjustment incorporates the impacts of both potentially higher interest advancing payments to the floating rate bondholders and additional term defaults associated with the interest payment volatility. The default frequency at balloon is identical for both fixed rate and floating rate CMBS. This adjustment is further calibrated to reflect the joint probability of simultaneous interest rate and real estate stresses. As in the fixed rate CMBS rating methodology, the final step consists of portfolio adjustments for elements such as diversity, structural characteristics and quality of underwriting.