Wall Street Shopping for CMBS Ratings as Warnings RaisedSarah Mulholland
Wall Street is increasingly shopping around for good credit ratings in the booming commercial-mortgage bond market as lending standards slip.
Banks are avoiding Moody’s Investors Service grades on new deals as the firm demands extra protection from defaults and instead are favoring raters that take a more optimistic approach. Moody’s hasn’t rated any of the riskier portions of the 14 CMBS deals issued since April, according to Bank of America Corp.
“The selection bias is sowing the seeds for the acceleration in loosening underwriting standards,” Richard Hill, a debt analyst at Morgan Stanley, said by telephone after warning in a report this week that the lack of a Moody’s grade is a “canary in a coal mine” for the market. “This has shades of pre-crisis underwriting trends.”
Risks in the $550 billion market for commercial mortgage-backed securities are growing as investors searching for higher-yielding assets accept bonds backed by loans with looser terms.
Landlords are taking on bigger debt loads relative to the values of their properties, making it harder to refinance their mortgages and increasing the chance that defaults rise if rents or occupancies decline. Moody’s in April likened the situation to a case of “boiling frog syndrome,” where investors fail to react to gradually increasing threats until it’s too late.
Ratings shopping helped to fuel the subprime-mortgage crisis as graders including Moody’s and Standard & Poor’s, the two biggest firms, lowered standards to win business while allowing banks to bundle increasingly risky mortgages into securities with a AAA stamp, the Federal Crisis Inquiry Commission said in its January 2011 assessment of the credit seizure.
New firms including Kroll Bond Rating Agency Inc. have sprung up since the crisis, giving issuers a broader pool to choose from and helping to revive issuance that froze during the credit seizure in 2008.
Analysts are forecasting sales of as much as $100 billion this year after they doubled to $80 billion in 2013, according to data compiled by Bloomberg. A record $232 billion was sold in
Moody’s was absent from all but the safest portions of a $1.2 billion commercial-mortgage deal sold last week by Deutsche Bank AG and Cantor Fitzgerald LP, Bloomberg data show. Fitch Ratings and Kroll were hired to grade most of the rest, while Kroll was the sole rater on $26.4 million of the lowest-ranking bonds, the data show.
Representatives from Deutsche Bank and Cantor declined to comment. Both Kroll and Fitch said higher levels of investor protections are being worked into commercial-mortgage bond deals as underwriting standards slip.
“Our criteria is designed to differentiate deals on the basis of credit and we have been consistent with our analysis,” said Kim Diamond, head of structured finance at Kroll. Fitch analyst Huxley Somerville said in e-mailed statement that as leverage increases and underwriting quality declines his firm also is demanding higher levels of protection known as credit enhancement.
S&P isn’t a dominant player in the biggest part of the commercial-mortgage bond market, meaning the majority of the riskier bonds in deals this year are being rated by Fitch, DBRS Ltd. and Kroll, the Bank of America analysts wrote in a report last week.
“We are comfortable that our approach has been consistent over time,” Erin Stafford, a managing director in the CMBS group at DBRS, said by phone. “As the market comes back and underwriting starts to loosen, our credit enhancement has increased.”
Those larger cushions against losses haven’t increased enough to offset the risk from higher leverage in new loans, Credit Suisse Group AG analysts led by Roger Lehman in New York wrote in a report today.
While investors have largely been unfazed by banks dropping Moody’s from new deals, they recently started pushing back as geopolitical turmoil from the Middle East to Ukraine slowed demand for risky assets, according to the Bank of America analysts led by Alan Todd. Some investors also are being sidelined because they can’t buy a security without a rating from one of the two biggest graders, allowing hedge funds to fill the void and demand higher yields, they said.
In the Deutsche Bank and Cantor deal, the lenders increased the yield on bonds rated BBB-, the lowest investment-grade ranking, before it was sold last week. The securities priced to yield 370 basis points more than benchmark rates, up from the 350 basis points initially proposed, according to people familiar with the offering, who asked not to be identified because terms aren’t public. Bank of America and Morgan Stanley sold similar debt last month with a spread of 310 basis points, or 3.1 percentage points.
“Market feedback increasingly suggests that investors share our views on CMBS credit quality,” Moody’s analyst Tad Philipp said in a telephone interview.
Banks last year started dropping Moody’s from the riskier portions of some transactions, which include as many as a dozen classes to meet differing risk appetites for buyers ranging from hedge funds to insurance companies. The credit grader started demanding more protection from defaults for investment-grade bondholders than other rating companies, eating into underwriters’ profits.
Issuers have become even more selective this month, with two deals lacking a Moody’s rating on all but the safest bonds, a sign of deepening concern that the quality of loans is falling, according to the Morgan Stanley analysts.
Bond underwriters get feedback from numerous firms on potential deals, typically choosing the one that provides the most-favorable ranking.
Lawmakers have been pressing the U.S. Securities and Exchange Commission to implement reforms from the 2010 Dodd-Frank law that would revamp the business of credit ratings. Senators including Jeff Merkley of Oregon and Al Franken of Minnesota sent a letter July 28 to SEC Chair Mary Jo White asking the agency to curb ratings shopping across fixed-income markets.
With central bank stimulus fueling demand for risky assets, concerns are mounting that banks are loosening standards to feed investor appetites. One measure of risk in CMBS, the size of a mortgage relative to a property’s value, a ratio known at loan-to-value, or LTV, has been climbing.
A $1.2 billion deal issued by JPMorgan Chase & Co. and Barclays Plc on Aug. 6 had an LTV of 114.8 percent, the highest of any deal since the crisis, according to Moody’s. Deals in the second quarter averaged 108.3 percent. While that’s down from a high of 118 percent in 2007, LTV levels are rising at a pace that would approach the pre-crisis peak by 2017, Moody’s said in a report last month.
“The ongoing credit slippage will set the stage for the next phase of the credit cycle,” Moody’s analysts led by Philipp wrote in a report last month.