Jerri-Lynn here. Plus ça change -I finally caught up with The Big Short on a recent transcontinental flight. Didn’t we learn anything from the Great Financial Crisis?
There is a fairly new and popular creature in the hopping party-town of securitizations: “commercial-real-estate Collateralized Loan Obligations.” These CLOs are bonds backed by risky commercial real-estate “transitional loans,” such as loans to fix up malls, dilapidated apartment buildings, and the like, with the hope that the property will then produce higher rental income. The loan is based on this hoped-for higher cash-flow. But that calculus might be wrong. And lenders want to off-load this risk. So they package the loans into commercial-real-estate CLOs.
Commercial-real-estate CLOs are a cross-breed between a regular Commercial Mortgage-Backed Security (CMBS), which is backed by mortgages on office towers, shopping malls, apartment buildings, student housing, and the like; and a CLO, which is backed by junk-rated corporate loans. So these commercial-real-estate CLOs are the riskier sisters of CMBS.
Banks that extend these types of risky commercial-real-estate transitional loans try to offload that risk to investors by securitizing these loans into highly-rated bonds that investment banks then sell to investors, mostly institutional investors such as pension funds.
Structured securities, including commercial-real-estate CLOs, have slices that take the first lost – the “credit enhancements” – and that carry the lowest credit rating. Investors in the higher-rated slices are protected by investors in the lower-rated slices that take the first loss. So the top slices can be rated triple-A, even if the debt that backs the security is very risky. The bigger the slices that take the first losses, the more protection investors have at the upper end. So far, so good.
The challenge for issuers is how to get a larger portion of these slices to sport investment-grade credit ratings, though by definition, this would thin the protection for these slices provided by the remaining lower-rated slices. The solution: Go shopping until you find the credit rating agency that promises the highest credit ratings.
Ratings agencies have responded to the competitive pressures by changing their criteria in rating commercial-real-estate CLOs in order to beat other ratings agencies and get the business.
And the business is booming. In 2019, banks offloaded $21.4 billion of commercial-real estate CLOs to investors, up from less than $1 billion in 2012, according to the Wall Street Journal, citing data from TREPP, which tracks CMBS.
The ratings agencies that most actively compete to rate these commercial-real-estate CLOs are Kroll Bond Rating Agency, DBRS Morningstar (after Morningstar acquired DBRS in June this year), and Moody’s. They get paid by the issuer of the bonds. And the issuers want the highest ratings on the biggest portion of the bonds.
That’s where the shopping starts. According to the WSJ, banks approach the ratings agencies with a specific deal. The ratings agencies then provide “initial feedback” on how they would rate the bonds, and banks can see which agency would provide the highest credit ratings, and they hire the firms then based on that feedback.
To get more of this business, two of the rating agencies have changed the criteria of rating commercial-real-estate CLOs.
Kroll changed its criteria in 2017. The WSJ:
A comparison of Kroll’s old methodology and its new one shows that the firm relaxed some rent and occupancy stress tests for mortgages financing multifamily apartment buildings – a big part of the market for these loans. That could yield higher ratings, according to current and former ratings analysts.
DBRS, after having been leapfrogged, changed its criteria in March 2019. The WSJ:
The change included a new ratings model that assigns a lower probability of default to multifamily versus other property types, according to Erin Stafford, DBRS’s head of North American commercial mortgage-backed securities analysis. She said the new model was implemented because of its higher predictive power, not due to commercial considerations.
“This is hauntingly familiar of legacy agency behavior precrisis,” the head of Kroll’s real-estate group, Eric Thompson, told the Commercial Mortgage Alert in June, accusing DBRS of easing rating standards in order to get the business and the fees, after Kroll had itself changed the criteria in 2017.
Morningstar, after acquiring DBRS, said that DBRS Morningstar would use the new criteria of DBRS, which were, according to the WSJ, “generally considered less conservative than Morningstar’s.”
DBRS is a “learning organization” that updates its methodology to incorporate new data and analytical approaches, it told the WSJ. Other ratings agencies “presumably do the same.”
In other words, the race to the bottom is on. And this is how it works in practice, according to the WSJ: A real-estate lender shopped the three ratings agencies last spring to rate the eight slices of a commercial-real-estate CLO.
- Moody’s in its feedback to the lender said about half of the slices would be rated triple-A; it was hired to rate only one of the slices.
- Kroll in its feedback to the lender said about 61% of the slices would be rated triple-A; it was hired to rate “a handful” of slices.
- DBRS said in its feedback that two-thirds would be rated triple-A; it was hired to rate all eight slices.
DBRS’s victory came after it had changed its ratings criteria that then gave more slices the top rating, thereby thinning out the loss-absorption cushion for the triple-A rated slices.
And this ratings-shopping is standard industry practice. According to data from the Commercial Mortgage Alert, cited by the WSJ:
- In 2017, DBRS led the commercial-real-estate CLO ratings game with getting 10 of the 18 total deals.
- In 2018, Kroll won the game, by getting 21 of the 25 total deals; after having changed its criteria in 2017, in response to getting clobbered by DBRS that year.
- In 2019, since changing its criteria in March, DBRS got 16 of the 24 total deals. Kroll only got 9 deals.
One of the deals where DBRS won was a $650 million commercial-real-estate CLO sold by Arbor Realty Trust Inc. in May. Under its new criteria, DBRS issued investment-grade ratings on such a large portion of the CLO that a loss of only 14.5% of the underlying loans would eat through the loss-protection cushion; any additional losses would eat into the investment-grade slices. This is down from a loss-protection cushion of 21.5% on a similar deal by Arbor that DBRS rated in 2018 before it changed its criteria.
The commercial-real-estate CLO market is only a small segment of commercial-real-estate structured securities, but the pressures are the same: To beat other ratings agencies and get deals and the fees, ratings agencies offer higher ratings on riskier debts.
And everyone is happy. The ratings agencies that get the deal are happy because they’re getting the fees. The issuer is happy because the deal got more appealing credit ratings. And investors are happy because they were able to buy highly rated securities backed by risky commercial-real-estate transitional loans, which is a hot thingy, and they don’t really care about the thinning loss protection cushion since there is never ever going to be another default and because they’re too busy chasing yield.