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SEC Shines a Light on Inflated CMBS Ratings

On January 21, S&P settled a number of complaints with the Securities and Exchange Commission as well as two states’ attorneys general.  The issues primarily involved ratings of Commercial Mortgage Backed Securities (CMBS), although the rating agency also paid a relatively small fine for a self-reported lapse in its RMBS monitoring.

The settlements show that the SEC making use of the new regulatory powers it gained under Dodd-Frank and the earlier Credit Rating Agency Reform Act of 2006. While the complaints illustrate the fact that commercial considerations continue to affect credit ratings in the post-crisis era, regulators were able to identify and address (some of) them before another disaster occurred.

The CMBS market is much smaller than RMBS market was in its heyday, so a wave of unanticipated CMBS defaults may not have been enough to trigger another financial crisis on its own.  Nonetheless, it is nice to know that (some) misbehavior was caught early — so we won’t have to find out.

Another difference between the contemporary CMBS market and the RMBS market of yore is greater competition. Six rating agencies currently vie for CMBS ratings mandates:  the “Big Three” plus DBRS, Kroll and Morningstar.  Neither Kroll nor Morningstar was around when bankers were shopping for higher RMBS ratings a decade ago.

After S&P temporarily suspended CMBS ratings in 2011, its market share position was quickly captured by Kroll. S&P’s subsequent misstep – distorting a Great Depression data set to justify lower AAA credit enhancements – was likely motivated by the fear of being permanently dislodged from the top three in a highly profitable asset class.

Ironically, the SEC enforcement actions, which include a one year suspension of conduit CMBS ratings, will cement S&P’s also-ran status. A takeaway here is one we have warned of many times previously: that more competition results in more ratings shopping by issuers and more pressure on rating agencies to dumb down their criteria – the type of concern that had motivated the Franken Amendment.


Competition in the Market for Single-Asset CMBS

S&P can still compete with the other players in rating single asset CMBS – a category that should worry any observer of the rating agency business. As the name suggests, single asset CMBS deals are collateralized by a mortgage on just one commercial property. The property can be an office building, a hotel or a shopping mall.

Typically investors in AAA structured finance paper have at least two protections:  seniority and diversification. With AAA securities at the top of the heap, collateral defaults usually have to destroy most or all of the value of more junior securities before the AAA holders are impacted. The second protection afforded to AAA structured finance investors is diversification:  the fact that the collateral pool contains a large number of loans whose risk attributes can be expected to offset one another.

Single asset CMBS deals kick this second protection away.  If the one loan backing the deal stops performing and has to be liquidated at a large discount, all investors lose – including those holding AAA paper.  The question in rating these deals is thus a fairly simple one:  what are the odds that the property will suffer a catastrophic loss in value?

According to the Moody’s idealized default probability table, the default probability on Aaa securities should be 0.0001% annually.  For an instrument rated Aa1, the annual default probability should be 0.0006%.  Differentiating between an event that has a 1 in 100,000 probability from one that has a 1 in 16,667 probability is difficult for any mere mortal – even one that happens to be employed by a credit rating agency.

But is it really credible to believe that any given shopping mall has just a 0.0001% chance of a catastrophic decline in value?  A brief review of recent history should refute this notion.

We have already seen one shopping mall devastated by a terrorist incident.  Although this tragedy happened in Nairobi, similar events are possible in the US which has already seen mass shooting incidents at Florida and New Jersey shopping centers.  But shopping malls can easily be laid low without an act of violence.  The closing of an anchor store or the opening of a competing mall can decimate traffic in short order.  And these aren’t theoretical possibilities as one can see by perusing the Dead Malls website.  This site lists over 100 US shopping malls that have closed or become largely vacant in recent years. Indeed, the rise of standalone big box stores like Walmart and the increased popularity of online commerce have placed enormous pressure on the entire shopping mall business.  Earlier this month, large tenants Macy’s and J.C. Penney both announced the pending closure of tens of stores around the country.

With such obvious risks, it’s hard to understand how a security collateralized only by a single shopping mall loan could be rated AAA.  Yet despite previous defaults on AAA shopping mall loans (see below) we continue to see AAA single shopping mall deals in the aftermath of the financial crisis.

Interestingly, the two pre-crisis shopping mall transactions with defaulted AAA securities weren’t single loan transactions – but they were overly dependent on individual loans that went bad.  Bear Stearns Commercial Mortgage Securities Trust 2007-PWR15 contained a loan to Las Vegas’ World Market Center II that accounted for 12.3% of the deal’s collateral pool. The default on this loan, in 2010, together with a large loss on the Aiken Mall in Aiken, SC have proved sufficient to trigger losses on the Aaa-rated AJ class.

CSFB Commercial Mortgage Pass-Through Certificates Series 2005-C2 included an exposure to the Tri-County Mall in Cincinnati that accounted for nearly 10% of its collateral pool. The liquidation of this mortgage at a deep discount eventually inflicted losses on AAA investors.

Despite these cautionary tales, we now have at least seven post-recession deals, with 100% exposure to a single shopping center, carrying AAA senior ratings.  These deals and their associated malls are as follows:

Aventura Mall
Miami, FL
Tysons Galleria
McLean, VA
Fashion Show Mall
Las Vegas, NV
Santa Monica Place
Santa Monica, CA
Green Acres Shopping Center
Valley Stream, NY
North Star Mall
San Antonio, TX
Altamonte Mall
Altamonte Springs, CA

If readers are aware of others, please pass them along.