Coronavirus Could Kill Overvalued Commercial Mortgage Backed Securities (CMBS)

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S&P caught up by downgrading the CMBS in just one time by 9 notches from AAA to BBB-, just a cut above the junk.

By Marc Joffe consultant for PF2 Securities:

The COVID-19 virus will have a particularly severe impact on Commercial Mortgage Backed Securities (CMBS), bonds backed by mortgages on non-residential properties. According to data from DBRS Viewpoint, more than half of mortgages in CMBS transactions are for offices, hotels and commercial buildings – three categories particularly affected by on-site shelter orders.

If shelter-in-place restrictions are lifted quickly and everything returns to normal immediately after, most of these properties could continue to service their mortgages. But if we instead enter a new standard of increased telecommuting, reduced travel and increased online shopping, thousands of office buildings, hotels and shopping centers will be missing.

This wave of potential defaults will first expose the madness of poorly structured and overvalued CMBS transactions. On the ratings side, the math started on March 20 when Standard and Poor’s downgraded (password required, but available for free) 60 bonds in 15 deals with concentrated retail exposure.

In its downgrade announcement, S&P said, “While COVID-19 is likely to have an accelerated effect on the decline in performance of properties exposed to retail, today’s rating actions do not specifically address the outbreak. virus. Thus, further “adjustments” to valuations may occur once the full impact of the coronavirus on retail is fully understood.

The most dramatic downgrades have been inflicted on undiversified single asset / single borrower securities that Joe Pimbley and I highlighted in a previous Wolf Street article. In this article, we focused on AAA Two Mortgage Backed Securities at Destiny USA, a mega-mall located in Syracuse, NY. This shopping center is partially closed until further notice. S&P has now downgraded these bonds five notches to A (Destiny USA, image via Wikimedia Commons):

S&P downgraded yet another single-borrower deal: Starwood Retail Property Trust 2014-STAR. This CMBS transaction is backed by mortgages on four shopping centers owned by Starwood Retail Partners. Although geographically diverse, three of the four shopping centers have lost key tenants. Starwood depreciated the value of its investment in the four properties by nearly 50% last May, and defaults on the underlying mortgage began in November, suggesting S&P stock is not particularly timely. S&P made up for its delay by downgrading the AAA ratings nine notches to BBB-, just one notch above the junk. S&P said:

While we believe the credit risk on Class A has increased, we also believe that its leading position in the cascade somewhat alleviates concerns about capital losses and interest deficits; and, therefore, we believe that the certificates continue to exhibit the credit characteristics of a lower quality security. However, if there are any negative changes reported in the performance of the property beyond what we have already considered, we can revisit our analysis and adjust the rating if necessary.

It has thus left the door open to a rapid deterioration in security in undesirable territory as the coronavirus situation evolves. Potential buyers of this security would have been better served by more active monitoring of this operation which would have resulted in several more modest downgrades, rather than by the sudden reduction of a supposedly risk-free security to the edge of high yield.

But rating agencies have little incentive to carry out the necessary oversight. They are paid by the issuers of transactions and lower credit standards competitively to secure contracts with the issuers. They are also under pressure from owners of securities who hate downgrades, which may require markdowns or forced sales of instruments in their portfolio (since some asset managers require their holdings to be equal to or greater than one. certain notation).

To S&P’s credit, they were quicker to recognize their insanity than some others. As of March 23, for example, the Kroll Bond Rating Agency is still rating Destiny USA senior bonds at AAA. And DBRS Morningstar Ratings still listed Starwood 2014 senior ratings at AAA. It therefore appears that the newer and smaller rating agencies are not yet improving the capacity to monitor rating activity.

While bond issuers and rating agencies cannot be expected to predict the coronavirus crisis, they should not encourage the creation of AAA securities which are thus exposed to event risk. A single property is not only vulnerable to pandemics, but also terrorist attacks and weather disasters, not to mention the financial distress of key tenants such as Macy’s.

But the overvaluation of poorly diversified CMBS titers continued until the start of the virus epidemic. On March 5, Moody’s (password required) and DBRS Morningstar both assigned provisional Aaa / AAA ratings to Class A certificates issued by BX Commercial Mortgage Trust 2020-VIVA. This agreement is secured by a mortgage on the MGM Grand and Mandalay Bay resorts in Las Vegas. As the Wall Street Journal reports today, Citigroup has not been able to sell these titles, which begs the question whether they were really AAA in the first place. By Marc Joffe, consultant for PF2 Securities.

“A dozen years after the financial crisis, rating agencies remain a weak link in the financial system. We don’t know when the next financial storm will happen or what it might look like, but overvalued commercial mortgages are clearly a vulnerability, ”Marc Joffe wrote in December 2019.

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