Slipping Standards in Commercial-Mortgage Debt Raise Fitch Alarm

Fitch Ratings is joining Moody’s Investors Service in warning that the credit quality of bonds backed by real estate debt is slipping at the same time that underwriters show reluctance to strengthen safeguards against losses.

Fitch offered a negative opinion on four recent commercial mortgage-backed securities deals that received top ratings from the credit grader’s competitors. In those transactions, Cantor Fitzgerald, Citigroup Inc., Credit Suisse Group AG, Deutsche Bank AG, Goldman Sachs Group Inc. and Wells Fargo & Co. bundled risky loans into securities that may not adequately protect investors from losses, Fitch said in a report on Monday.

“Had Fitch rated each of these four CMBS deals, either the credit enhancement would have been higher at each rating level or the ratings themselves would have been lower,” Huxley Somerville, head of the ratings firm’s commercial mortgage securities group, said in the report.

Representatives for Cantor Fitzgerald, Citigroup, Credit Suisse, Deutsche Bank and Goldman Sachs declined to comment. A spokeswoman for Wells Fargo didn’t respond to telephone messages seeking comment.

Moody’s has been shunned from deals for nearly two years, when underwriters first began to consider its rating methodology as too conservative.

In light of worsening underwriting conditions, the firm said last week in a report that it would require extra protection on bonds that are subject to some of the first loan losses. Moody’s hasn’t been hired to rate any of those securities all year. The firm maintains that there’s a 5 percentage-point difference between the levels of credit protection it would require and where deals are now getting done.

Goldman Deal

Underwriters are increasingly stuffing U.S. offerings with higher-risk assets and selling them with fewer safeguards against default.

When Goldman Sachs sold $1.15 billion of mortgage bonds last month that were mostly backed by various hotel and office spaces, a majority of the deal involved riskier loans that only required borrowers to make interest payments, and not pay down principal, during at least part of the terms.

The offering, which Citigroup also underwrote, had 10 interest-only loans and 40 that were interest-only for part of the term, according to data from Moody’s. Together they accounted for the majority of the total pool. The deal was packaged with the lowest guarantee against losses of any similar transaction this year, Wells Fargo data show.

Taken Aback

Kroll Bond Rating Agency Inc. and the credit-ratings unit of Morningstar Inc. assigned AAA ratings to the majority of the deal. Moody’s rated portions of the deal AAA, but it was not hired to grade the riskiest pieces. Kroll and Morningstar graded those.

Representatives from Kroll and Morningstar declined to comment on the deal.

Fitch was “taken aback” after submitting its rating proposal to Goldman and Citigroup, Somerville said in an interview. The underwriters told Fitch that other credit graders offered AAA ratings on some bonds with credit protection that was 2 percentage points to 3 percentage points lower than what Fitch would have required for the top ranking, he said.

“The expectation is pretty clear,” said Bill Irving, a money manager at Boston-based Fidelity Investments. “Things are going to get more aggressively underwritten the rest of the year.”

Credit protections required by bond graders on the most popular type of commercial mortgage bonds have fallen in the second quarter to their lowest average level this year, Wells Fargo data show.

Ratings Competition

Credit enhancement measures, which bond graders require in order to assign higher ratings, have fallen 0.4 percentage point this quarter to 23.2 percent, indicating even lower levels of protection for investors than recently noted.

Irving blames ratings competition for the variances.

“It is hard to say who is right and who is wrong, but increased competition and the tendency for Moody’s or Fitch to only rate part of the deal, that gives license for lower credit enhancement,” Irving said. “It is a result of the shopping that is going on.”

The result is that banks are walking away from more established graders such as Moody’s and Fitch when it comes to rating the riskiest pieces of their securities. In the second quarter, Moody’s has been excluded from all subordinated bonds, according to JPMorgan Chase & Co. analyst Meghan Kelleher. Those are bonds with the highest risk of default.

Fitch’s market share fell after it demanded more loss protection for top grades, Kelleher wrote in a client presentation last week. She also blamed the trend on ratings shopping, and said that banks are avoiding Fitch because its stricter metrics require several percentage points more in credit protection for bonds rated by the firm.

The trend has opened the door for more rating firms such as Kroll and Morningstar to offer their opinions.

“The majors are being sent down to the minors,” Kelleher said.

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