Moody’s Investors Service plans to grant top ratings to U.S. commercial-mortgage bonds with less investor protection and potentially riskier underlying loans than in the market’s previous sale.
Almost $609 million of securities being sold by JPMorgan Chase & Co. with so-called credit enhancement of 15 percent will get Aaa grades from the New York-based ratings firm. In this year’s only other sale of such debt, the amount of protection against the underlying loans’ losses, such as by having junior- ranked notes lose principal first, totaled 22.3 percent.
The latest securities contain mortgages that are larger in relation to the properties’ values and the amount of income from tenants. At the same time, the bonds will be linked to 36 different loans, compared with only six in an April sale by Royal Bank of Scotland Plc. The greater diversity is the main reason Moody’s is allowing the lower credit enhancement, according to Nick Levidy, an analyst at the firm.
“The benefit of diversity is very significant in that range” of difference in the amount of loans, Levidy said yesterday in a telephone interview.
That reasoning represents “exactly the same types of mistakes” made by ratings companies in assigning top grades to commercial- and residential-mortgage bonds later proven flawed as property markets collapsed across the country, said Donald van Deventer, chief executive officer of Honolulu-based Kamakura Corp., which sells risk-management software and advice to financial firms.
“The argument that diversity offers a huge benefit would work if you were talking about flipping coins,” van Deventer said. “They act as if real-estate moves around in an independent fashion.”
Since the credit crisis, Moody’s has “increased the correlation” assumptions it uses, Levidy said. “All else being equal, it tends to lower the diversity benefit.”
The JPMorgan securities are backed by $716.3 million of mortgages with an average loan-to-value ratio of 61.5 percent and debt-service-coverage ratio of 1.64 percent, according to Moody’s pre-sale report. In the Royal Bank of Scotland sale, the $309.4 million of loans’ LTVs averaged 54.3 percent and debt- service-coverage ratio was 2.51 percent, according to Bloomberg data.
Moody’s ratings on the most recent deal also were boosted by the fact that the underlying mortgages contain loans tied to more types of properties, rather than almost exclusively retail and office buildings, as well as fewer office buildings, which the firm considers among the riskier sectors, Joe Baksic, another Moody’s analyst, said in an interview.
A larger number of underlying mortgages helps offset the “idiosyncratic risks” that can come up with individual ones, said Bryan Whalen, co-head of the mortgage- and asset-backed bond group at Los Angeles-based TCW Group Inc., which oversees about $115 billion.
“There’s definitely a benefit to diversity, though there’s obviously a difference of opinion in the marketplace about how much of a benefit,” Whalen said.
New York-based Fitch Ratings, which didn’t rate the commercial-mortgage-backed securities sold earlier this year, plans to assign AAA ratings to the same bonds as Moody’s.
The deal’s strengths, Fitch said in a report, include the fact that “a large portion of the portfolio is anchored by national or large regional tenants, including investment-grade tenants” such as Walgreen Co., CVS Caremark Corp. and Wal-Mart Stores Inc. Still, having 71 percent of the debt tied to retail is a risk amid the “broad-based stresses” on the sector from the weak economy, according to the report.
Moody’s credit-enhancement requirements remain higher than before markets collapsed, even though loans are less risky than during the boom, when mortgage amounts were “well north” of true property values, Baksic said. In a June 2007 securitization of commercial mortgages by JPMorgan, the lowest-ranked Aaa securities carried credit enhancement of 12.2 percent, Bloomberg data show.
The ratings company may simply be loosening its requirements to reflect it recently seeking protection against “end-of-the-world scenarios,” in part to compensate for its past mistakes, said Anthony Sanders, a professor of finance at George Mason University in Fairfax, Virginia, and former Deutsche Bank AG mortgage-bond research director.
“They underpriced default risk on the way up, and they were heavily criticized for it, and then they were overly cautious on the way down,” he said. “They should be, in fact, lightening up on their credit enhancements, but they’re not going to say that’s the reason they are.”
Based on testimony to Congress this year by former employees about rating-firm practices during the securitization explosion ended in 2007, Moody’s may simply be seeking revenue for itself and market share, Kamakura’s van Deventer said.
“The cynical response is: The reason is that, unless they actually rate something that can get done, they’re not going to get bonuses this year,” he said.
Levidy declined to talk about its discussions with New York-based JPMorgan. Justin Perras, a bank spokesman, declined to immediately comment.