Sarah 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 favouring raters that take a more optimistic approach. Moody’s had not rated any of the riskier portions of the 14 commercial mortgage-backed securities (CMBS) deals issued since April, Bank of America said.
“The selection bias is sowing the seeds for the acceleration in loosening underwriting standards,” Richard Hill, a debt analyst at Morgan Stanley, said after warning in a report this week that the lack of a Moody’s grade was a “canary in a coal mine” for the market. “This has shades of pre-crisis underwriting trends.”
Risks in the $550 billion (R5.9 trillion) 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 of defaults rising 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 is too late.
Ratings shopping helped to fuel the subprime mortgage crisis as graders including Moody’s and Standard & Poor’s (S&P), 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 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 $100bn this year after CMBS issues doubled to $80bn last year, Bloomberg data show. A record $232bn was sold in 2007.
Moody’s was absent from all but the safest portions of a $1.2bn commercial mortgage deal sold last week by Deutsche Bank and Cantor Fitzgerald, 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. Kroll and Fitch said higher levels of investor protections were being worked into commercial mortgage bond deals as underwriting standards slipped.
“Our criteria is designed to differentiate deals on the basis of credit and we have been consistent with our analysis,” said Kim Diamond, the head of structured finance at Kroll.
Fitch analyst Huxley Somerville said that as leverage increased and underwriting quality declined Fitch was demanding higher protection known as credit enhancement.
S&P was not a dominant player in the biggest part of the commercial-mortgage bond market, meaning the majority of the riskier bonds in deals this year were being rated by Fitch, DBRS and Kroll, 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 had not increased enough to offset the risk from higher leverage in new loans, Credit Suisse analysts wrote in a report yesterday.
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.
Some investors were being sidelined because they could not 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 are not 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.
Banks in 2013 started dropping Moody’s from the riskier portions of some transactions, which include 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 favourable ranking.
Legislators have been pressing the US Securities and Exchange Commission to implement reforms from the 2010 Dodd-Frank law that would revamp the business of credit ratings.
With central bank stimulus fuelling 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 as loan-to-value, has been climbing.
“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. – Bloomberg