A major development in the commercial mortgage-backed securities sector in the last few years has been the reduced appetite for aggregation risk on the part of issuers and originators, according to Moody's Investors Service, and the rating agency recently published a research report addressing how it rates loans greater than $50 million - known as "large loans."
According to the report, by Moody's senior vice president Sameer Nayar, Moody's analysis of large loans focuses on the credit characteristics of the asset, the structural features of the transaction and the impact of diversification in a cross-collateralized pool situation.
Large loans generally range in size from $50 million to $500 million with overall debt limited to investment-grade levels. According to Moody's, because of significant spread volatility and reduced appetite for subordinate tranches of higher leveraged loans, issuers have focused on limiting the first mortgage debt to investment-grade levels, while filling in the gap by introducing some form of subordinated debt behind the first mortgage.
Moody's rating approach for securities backed by large-loans compares the credit risk inherent in the underlying asset with the credit protection offered by the structure. The credit risk on the underlying asset is determined primarily by two factors: the frequency of default, which is largely driven by the debt service coverage ratio (DSCR), and the loan-to-value of the underlying loan, which impacts the severity of loss in the event of a default.
The structure's credit enhancement is quantified by the maximum loss of value on the asset the securities are able to withstand under various stress scenarios without causing an increase in the expected loss for various rating levels.
According to the report, one of the fundamental concepts of structured finance is the carving out of multiple tranches based on different risk profiles, which lead to different ratings. Moody's believes the highest rating levels can be achieved for bonds backed by a single asset/loan as long as there is an appropriate level of certainty about the residual value of the underlying real estate, and there are appropriate provisions for liquidity.
Additionally, the report contends that amortization is a powerful tool to mitigate refinancing risk and help offset the loss in value of the asset due to physical depreciation.
Therefore, Moody's has also developed an approach to distinguish between loans that have a faster or slower amortization schedule relative to certain benchmarks.
As in any CMBS deal, the rating of the structured bond in a large loan/single borrower transaction is generally based on the sufficiency of the cash flow generated by an underlying real estate asset.