In light of several non credit-related downgrades of CMBS classes - all involving interest shortfalls - the rating agencies are considering whether to incorporate the risk of a temporary interest shortfall from the risk of non-credit issues, such as litigation, servicer advancing and others.

"There's concern that a small dollar impairment may be reflected in an outsized rating downgrade," said Mary Stuart Freydberg, an analyst at Merrill Lynch.

Researchers at Merrill said that the issue of missing an interest payment might mean serious credit issues in the corporate bond-rating world, but the same might not hold true for structured finance. They added that this issue is breaking new ground in the rating agency world and must be incorporated with agency-wide ratings, actions and fundamental principals.

The recent negative ratings actions include Moody's Investors Service putting the ratings of classes from nine commercial mortgage-backed deals on watch for possible downgrade because of interest shortfalls. The shortfalls were due to legal fees and other expenses incurred by the master servicer (Wells Fargo) pertaining to terrorism insurance.

Fitch Ratings also recently placed three classes from two single asset deals on Rating Watch Negative for the same reason. The rating agency also previously placed another three classes from three single asset deals on Rating Watch due to interest shortfalls caused by expense reimbursements in each deal.

Standard & Poor's was also notified earlier this year that Wells Fargo will pass terrorism insurance-related expenses through to the trusts of various CMBS transactions, causing interest shortfalls. The rating agency said that even though the shortfalls are not likely to be recovered by investors, analysts did not deem any rating action necessary. They considered the shortfalls isolated events as well as economically diminutive so as not to imply any weakening in the collateral. A downgrade of the affected classes would not "accurately reflect the current credit characteristics of each transaction," they noted. S&P also stated that it will continue to assess its position as the terrorism insurance issue evolves and in light of future actions deemed necessary by the servicer.

Analysts said they would take into consideration factors such as how meaningful is it to set a D' rating for the bondholders, though technically there is already a default. Toward the end of last year, S&P placed its ratings on three classes of Four Times Square Trust's commercial mortgage pass-through certificates series 2000-4TS on CreditWatch with negative implications due to interest shortfalls.

In a recent report, Merrill analysts noted that Moody's rating definitions include an assumption based on anticipated recovery, which can actually be less than 100%. On the other hand, Fitch and S & P's ratings are characterized as reflections of default with 100% return of principal. They added that of the three rating agencies, Moody's seems to have more rating flexibility and therefore, the rating agency's transitions may be relatively smooth with fewer jumps from investment grade to "D."

She commends the rating agencies for being careful and thoughtful about their ratings. "I think they are doing the right thing by putting the investment community on notice," Freydberg said. She added that servicers have also been put through the test of how and when to pass through interest shortfalls.

Rating agency side

Rating agencies are weighing the consequence of having an investment-grade bond experience an interest shortfall that is unrelated to the real-estate credit, especially in light of the fact that it took extraordinary circumstances - the destruction of the World Trade Center and the dislocation of the insurance market - to cause it.

"We have rated a hundred or so large loan deals over the last decade and this is the first non-credit issue that has affected them," said Tad Philipp, managing director at Moody's. "So we are weighing how likely it would be for non credit-related events to occur again and whether or not there should be reserves or structural improvement to address these issues."

In these situations, the interest shortfalls are really not credit issues as servicing fees and shortfalls are outside the context of property fundamentals deteriorating or the borrower going through a restructuring or foreclosure. Philipp said that this is extremely unusual as the properties are performing as expected (although interest payments are being shorted).

In regard to the classes in nine single asset and large loan CMBS transactions that Moody's put on watch for possible downgrade due to interest shortfalls, Philipp said that "it's very hard for us not put a transaction on review when its next interest payment is going to be short."

In these instances, once the shortfalls have passed, the deals begin performing as expected. Interestingly, this could lead to an upgrade because ratings are forward-looking. "We are hoping in many cases to be able to restore the ratings," he said.

In rating transactions, Moody's looks at both the chance of default as well as the potential for severity, Phillipp said. A deal might have a higher chance of default but a very low degree of severity. For instance, when a borrower misses a portion of one month's interest payment out of a ten-year bond, there is a very small impact on an expected loss basis.

However, observers said that as there is a limited amount of recently issued large loan deals, and none are slated for the year, the issue has minimal impact on the CMBS market as a whole.

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