Analysis: Ratings shopping, inconsistency, haunt CMBS market

Thu Jul 28, 2011 9:14pm EDT

by Adam Tempkin

NEW YORK, July 28 (IFR) - Standard & Poor's has in recent months been the most outspoken rating agency warning investors about deteriorating underwriting and increasing leverage in the new batch of commercial mortgage-backed securities.

Ironically, S&P has now infuriated the investor community with a series of baffling and contradictory ratings moves in recent days that have only heightened investor uncertainty and undermined confidence in the reviving sector.

Market participants were shocked by S&P's sudden and last-minute announcement late Wednesday that it must review certain aspects of its methodology and assumptions before rating any new CMBS offerings.

S&P issued an "Advanced Noticed of Proposed Criteria Change" for conduit/fusion CMBS deals in order to review a glitch in its methodology for determining debt service coverage ratios (DSCR).

The rating agency discovered that it was employing "potentially conflicting methods" of DSCR calculations, with the review intended to 'harmonize' the DSCR issue, 'without changing the overall calibration of the conduit/fusion CMBS criteria'.

S&P declined to comment beyond its published criteria announcement.

As a result of the impending review, the agency withdrew ratings on the US$1.5bn GSMS 2011-GC4 transaction, which already priced on Friday, causing the transaction's sponsors, Goldman Sachs (GS.N) and Citigroup (C.N), to withdraw the offering from the market altogether early this morning, just a day before closing.

The deal was also rated by Morningstar, a relative newcomer to the structured-finance ratings space, but the lack of a 'core' rating from a Big Three rating agency meant that some investors would run into difficulties if the investment banks left the offering in the market following S&P's withdrawal.

"This is the first time to our knowledge that any CMBS has been pulled from the market post-pricing," wrote Lisa Pendergast, co-head of CMBS strategy at Jefferies & Co., in a client note this afternoon. "This is unprecedented."

S&P's move also calls into question whether other recent deals it rated would be downgraded in the near future as a result of its upcoming review. The answer is not yet clear.

AGGRESSIVE CREDIT ENHANCEMENT

But according to investors, what's most striking is the "counterintuitive" chain of events involving S&P's words and actions over the last two weeks that culminated in today's transaction withdrawal and market upheaval.

The ordeal highlights the level of inconsistency that still exists in some of the raters' approach to assessing certain structured securities, securitization specialists say.

Perhaps more importantly, it also illustrates what is considered to be an open secret in the industry: even after the passage of the Dodd-Frank Act, issuers still shop around among the rating agencies looking for the best execution on CMBS before choosing who ultimately rates a transaction.

The GSMS 2011-GC4 deal was only rated by S&P and Morningstar. According to Darrell Wheeler, head of CMBS strategy at Amherst Securities, normally investors would not be concerned about any single agency's rating on a transaction, but Morningstar was the only other rating "and they are still fairly new at rating new issues," he said.

"Along with the concern over having a new rating agency, several investors suggested rating shopping may have transpired on the transaction," Wheeler said.

"This suggests that the new issuance market still faces issues with rating agency credibility and investors confidence with those ratings."

Despite being at the forefront of publicly identifying troubling structural/underwriting trends in the new wave of deals -- even to the point of either turning down deals or being left off of them -- two weeks ago S&P allowed the most aggressive credit enhancement in "CMBS 2.0" so far, 14.5%, to underpin the Triple A classes on the US$1.5bn Goldman Sachs/Citigroup GSMS GC4-2011 conduit.

The surprising reversal confounded many in the market.

Regarding the initial thin credit enhancement level, one senior CMBS portfolio manager from a large, prominent asset management firm said: "S&P would have been the last guys I would have expected to do this, as they've been very conservative, and the first guys I would have expected -- because they've been the least in touch with reality.

"Nobody could figure out why S&P was more aggressive <with credit enhancement> when the underwriting was clearly worse."

He added: "As for ratings shopping, of course it happens on every deal. One of the adverse side effects of introducing all these new agencies is that there are a lot more to choose from."

"S&P speaks out of both sides of its mouth," added one senior CMBS trader.

PROTECTION PROBLEMS

However, S&P had its supporters.

Significantly, Morningstar agreed with the initial credit enhancement level of 14.5%, and in fact some researchers, including Mr. Wheeler, believe that the quality of the collateral was actually consistent with this level of protection, at least for the Triple A portions of the GC4 offering.

"We have been completely consistent in how we look at every transaction. You may not agree with us, but you understand how we got there," said Joe Petro, a managing director in Morningstar's structured finance unit.

"Every rating agency receives deal information at the beginning. We are selected to be on some deals, and not selected on others. If our subordination levels don't show well, we know we don't get on the deal. But we have a consistent approach."

However, some investors strongly disagreed with the initial thin layer of protection. In fact, S&P reportedly had private meetings with investors to allay their fears, and even held a public teleconference on Monday, July 18, to discuss the transaction and defend their ratings.

Besides the slight credit protection, the analysts expressed a few other concerns about the offering.

For instance, 22% of the loans were to borrowers who previously filed for bankruptcy. In addition, almost 35% of the loan pool had existing debt outside the trust, or had the ability to incur debt outside the trust.

Still, the credit quality of the underlying loans was strong, the analysts said.

But buy-side complaints that the credit enhancement protecting the Triple A tranches of the deal was too thin spurred the two investment banks to boost credit enhancement to 20% from 14.5%, and to revise price guidance wider on July 20.

This was seen as a major coup for investors, who had been trying to push back against issuers on high leverage and risky collateral since CMBS re-emerged in November 2009.

Importantly, there was no rating agency influence in the structural change last week. "Investors took the lead on this, and I think investor pushback is healthy for the market," the CMBS trader said.

The whole deal was restructured. Price guidance on the A4 tranche was increased from swaps plus 150bp to swaps plus 175bp last on July 20, and the size of the tranche was increased to US$672.482m.

Last Friday, the transaction priced with wider spreads. "It was clear to the market that the GC4 deal had credit enhancement levels that were too aggressive," wrote CMBS researchers from Morgan Stanley today. "If you look at final pricing on the mezzanine, those tranches priced as if they were rated about one notch lower."

The transaction was on track to close tomorrow. However, S&P stunned the market last night with it planned criteria revision and ratings withdrawal. Goldman and Citi announced this morning that they were going to scuttle the deal.

In regard to the specific offering, investors felt betrayed, saying that the removal of the transaction from the market caused by S&P's ratings withdrawal may ultimately undermine any leverage the buy-side has won in demanding fairer pricing from issuers for risky collateral.

The experience will also further marginalize the import of credit rating agencies in securitization markets, Jefferies' Pendergast said.

On the other hand, "today's drama will yield greater stability in new-issue CMBS go-forward," Pendergast wrote, "pressuring CMBS originators to remain diligent in their loan sizing and underwriting and underscoring to rating agencies the need not only to develop robust and transparent models, but also to team those models with some good old common sense."

(Disclaimer: Adam Tempkin was communications manager for Standard & Poor's structured finance group from 2002 through 2009)

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