Echoes of the Great Recession in Commercial Real Estate
After widespread condemnation of their contributions to the 2008 financial crisis, U.S. rating agencies largely avoided scrutiny during the coronavirus recession. In fact, the Federal Reserve used credit ratings to determine whether certain classes of borrowers should receive emergency loans and what interest rates they should charge. This move contradicted the spirit of Dodd-Frank, who tried to separate credit ratings from federal regulation, while underscoring the fact that the 2010 reform could not replace the views of highly conflicted private firms in overseeing the financial sector.
Unfortunately, these conflicts of interest persist and in some cases have been exacerbated by the entry of smaller competitors into the ranks of SEC-licensed Nationally Recognized Statistical Rating Organizations (NRSROs). These issues came under scrutiny in 2020 because the recession was caused by the pandemic rather than financial tech-niques gone wrong. Aggressive fiscal and monetary policies have also limited the number of major institutional failures we've seen so far. If highly rated but bankrupt companies continue to service their debts with government help, regulators can overlook the accuracy of their ratings. . . . In fact, high ratings can even be viewed as an expression of the possibility that the government will bail out a distressed borrower.
One category of bonds that has not yet received federal support is Single Asset / Single Borrower Commercial Mortgage Backed Securities (SASB CMBS). Like mortgage-backed residential real estate, which was crucial in the financial crisis, CMBS are serviced from principal and interest payments for a pool of real estate loans. However, the underlying mortgages are charges on property on large, income generating properties such as office buildings, apartment complexes, hotels, and shopping malls.
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While many CMBS deals are backed by dozens of mortgages, others are only backed by a handful of real estate. In some cases, the mortgage pool consists of a few properties owned by a single borrower or even just a single property.
The problem with single asset and single borrower transactions is the lack of diversification. Mortgage pools, which contain a mix of properties in different categories scattered across the country, are less likely to encounter circumstances where cash flows will decline catastrophically. While a mortgage on a mall in New York may stop working, its impact on the total flow of interest and capital will be diluted through the Houston office building and Florida apartment complex, which continue to pay and maintain their estimated value.
However, if the mortgage pool only includes the New York State Mall loan, its performance will depend in large measure on Governor Andrew Cuomo's health policies or adverse events such as an anchor tenant filing for bankruptcy.
It may be for this reason that the Federal Reserve banned CMBS transactions for individual assets and individual borrowers from eligibility when it restarted its Term Asset Backed Securities Loan Facility (TALF) in March. Under TALF, the Federal Reserve lends money to help investors purchase asset-backed bonds in the secondary market to support the prices of those assets. Although the program includes AAA-rated bonds backed by auto loans, credit card claims, leveraged bank loans, and commercial mortgages, SAS Fed Term Sheet specifically excludes SASB CMBS.
While the Fed recognized the increased risk of SASB-CMBS transactions, prior to the coronavirus recession, credit rating agencies were giving AAA ratings to hundreds of senior CMBS securities with poorly diversified collateral pools.
Many of these stores - especially those that are exclusively supported by malls - performed poorly in 2020, suffering from debt service disruptions and / or severe depreciation. In some cases, malls' performance had started to deteriorate well before the COVID-19 outbreak as e-commerce and local economic challenges reduced foot traffic.
In some cases, the rating agencies realized that their AAA ratings were no longer tenable and downgraded the senior bonds. Seven formerly AAA-rated CMBS securities backed by one to five mortgages have been downgraded by two or more notches (granular rating) since March. These so-called "fallen angels" include retail locations from New York to California.
Multi-notch downgrades of senior CMBS securities backed by shopping mall mortgages
In the two most extreme cases - one with a mall in Buffalo, New York, and one with four properties in different states - AAA securities were previously downgraded to speculative levels, reflecting the NRSRO's finding that the bonds are high risk. The market agrees. According to Solve Advisors, potential buyers of these two bonds are offering less than seventy cents on the dollar - an exceptional result for risk tolerant bondholders who have acquired these assets with the confidence that they will be safe from SEC-certified NRSROs.
Deals rated by Moody's are not shown in the table as I haven't recently found any CMBS downgrades for individual or large loans by this company. That does not mean, however, that Moody's completely avoided assigning SASB CMBS securities questionable AAA ratings (or, in Moody's case, Aaa).
One set of Moody's CMBS ratings that isn't aging well is the NCMS 2019-NEMA rating, a deal backed by a single luxury San Francisco rental home. Named San Francisco NEMA, the property has 754 residential units and 11,184 square feet of street-level retail space. Located across from Twitter's headquarters, NEMA was part of an ambitious plan to revitalize San Francisco's run-down mid-market neighborhood.
Unfortunately, Twitter is now leading the way in the transition to remote working, and in May it decided that most employees would still have the option to work from home even after the pandemic ended. A combination of remote work, lockdowns and riots has sparked a mass exodus from NEMA's San Francisco neighborhood. The rents for space have fallen by around 30 percent compared to the previous pandemic, while vacancies have increased. Recent (non-public) investor reports on NCMS 2019-NEMA show that the building's occupancy has dropped to 70 percent, compared to 94 percent at the start of the contract.
Despite the sharp drop in sales at NEMA in San Francisco, Moody's hadn't downgraded any of its ratings for NCMS 2019-NEMA. DBRS Morningstar, the other agency covering the deal, has also left most of its ratings unchanged. The AAA rating is retained not only for the highest class A certificates, but also for class B bonds that are subordinate to class A.
In contrast to the inflated subprime RMBS ratings of 2007, today's dubious SASB CMBS do not pose a systemic threat. The asset class is relatively small, as is the volume of derivative securities that reference these bonds. But rating errors in the SASB-CMBS sector provide evidence that the Dodd-Frank-era reforms did not fix the ratings industry and put in place a regime that could spark future financial collapse.
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