NEW YORK, May 17 (IFR) - Fitch shook up the US securitization market this week when, on the eve of a long-awaited US SEC public roundtable on credit rating industry reform, it issued an unsolicited comment lambasting the Triple A ratings given by two of its rivals to a new single-asset commercial mortgage-backed security (CMBS) linked to a trophy Manhattan office building.
For the first time ever in the US CMBS market, the unsolicited write-up was released publicly before the deal - called CGCMT 2013-375P - was even launched or priced, causing a media feeding frenzy that irked many in the market, not least the issuer and the rival rating agencies, Moody's and Kroll.
While this type of rating agency sniping has been going on over the past two years for nearly every structured finance asset class, it has never been timed in this way, according to industry participants.
Still, many investors believed Fitch had made a valid point: CMBS risk is ramping up again.
"The underwriters clearly emptied the old bag of tricks on this one, as far as crisis-era underwriting goes, and the agencies [fell for] them," said the head of CMBS investing at one of the biggest asset managers in the country.
"Those tricks included re-measuring the building, lowering management fees in order to minimize projected expenses, and creating an 'optimizing' structure that pushes as much away from the mezzanine debt into the securitization at the Triple B minus level.
They optimized the total securitization proceeds, and there are huge economics to be gained from that. The huge beneficiary is the borrower, who gets something like a 3.5% coupon," said the investor.
PRO FORMA LEVERAGE RETURNS
Fitch said this past Monday that the new large loan CMBS linked to the "prestigious" Seagram Building on Park Avenue was based on so-called pro forma income and had insufficient credit enhancement to warrant a Triple A rating. It would only have rated the senior tranche Single A.
Pro forma underwriting, an aggressive tactic that was the hallmark of risky commercial real estate lending at the height of the market from 2005 to 2007, bases future property cashflows on often wildly optimistic projections rather than in-place or realized income.
By issuing its one-page critique, Fitch, which was ultimately not hired to rate the deal, brought attention to the problem of ratings shopping just as the SEC, many members of Congress, and more than 25 panelists were set to discuss the very same topic as well as the future of the rating agency "issuer pays" model for the entire next day in the nation's capital.
But despite the fact that many investors agreed with Fitch's sentiments and concerns about the notably increased leverage in the controversial deal, the Triple A portion of the US$572.9m transaction was increased at pricing on Thursday from US$75m to US$209m. Spreads on the most subordinate pieces widened considerably, however. The deal was originally US$439.75m.
Each subordinated tranche had split ratings from Kroll and Moody's, with the former agency refusing to rate the most subordinated Class E slice.
The Class A tranche, rated AAA/Aaa (Kroll/Moody's), priced on the wide side of guidance at swaps plus 92bp; Class B, rated A-/Aa3, priced as expected at plus 135bp; Class C, rated BBB-/A3, widened to plus 175bp from initial price guidance of plus 170bp; Class D, rated BB/Baa3, widened the most to plus 245bp from talk of plus 215bp; and Class E, which Moody's rated at Ba3, widened to plus 310bp from guidance of plus 300bp. The lead underwriters were Citigroup and Deutsche Bank.
The underwriters securitized the entirety of the so-called subordinate, or junior, portion of a US$782.75m commercial mortgage on the Seagram building.
However, they only securitized part of the senior portion, known as the A loan, leaving the flexibility to increase the Triple A piece in the bond transaction. The remaining unsecuritized portion of the A loan will be put into an upcoming multi-borrower CMBS conduit.
There's no doubt that the Seagram Building deal portends a return to 2007 leverage and raises red flags, multiple CMBS experts said.
However, some investors theorized that the buyside viewed the total debt as aggressive but could live with the leverage.
"I think investors generally think favorably enough of the asset's intrinsic ability to add value to look through, perhaps, even stretched future cashflow assumptions, which is something of a symptom of the rate-repressed world we are obligated to operate in currently," said Christopher Sullivan, chief investment officer of the United Nations Federal Credit Union.
"While we don't look at single asset deals like this, I would guess that Triple A investors thought highly of the property," added Marc Peterson, a senior CMBS portfolio manager at Principal Global Investors.
"Moreover, all of the numbers are right there to look at, so investors can figure it out for themselves."
Moody's and Kroll told IFR, however, that even they generally thought that the issuer's initial projected numbers regarding net operating income, occupancy, expenses, structure, and other metrics on the top-notch building were way too aggressive.
Therefore, each agency assumed a steep haircut on the building's net cashflow and valuation in order to arrive at its Triple A enhancement levels.
Kroll assumed 17.9% less than the issuer's net cashflow and 46.7% below the appraiser's valuation, according to Eric Thompson, head of CMBS at Kroll. Meanwhile, Moody's undercut by 10.7% the underwritten cashflow, said Tad Philipp, director of commercial real estate research at Moody's.
"Investors are well protected, from a credit standpoint," Thompson said.
"This building is in the top three in New York," said Philipp. "It can attract tenants and capital. Even during a crisis, opportunity funds and others will line up to buy there."
Others in the market also said that Fitch was being hypocritical, conveniently picking and choosing which deals to make a stink about in a bid to get attention.
In January, Fitch rated a CMBS titled GSMS 2013-KYO, linked to six hotels in Honolulu, which was said to have used pro forma underwriting; similarly, last November Fitch gave Triple A grades to a deal linked to an office building, 1290 Ave of the Americas, with pro forma projections.
In response, the head of CMBS at Fitch, Huxley Somerville, said that Fitch used a highly stressed cashflow assumption on the deal backed by the Kyo-Ya hotel portfolio.
The underwriter, Goldman Sachs, used pro forma assumptions to calculate so-called Revenue Per Available Room (RevPAR), presenting a projected cashflow of US$174.4m. However, Fitch assumed a much lower cashflow at US$145.4m, Somerville said.
Similarly, on the deal backed by a loan on 1290 Ave. of the Americas in Manhattan, Somerville said there was a US$10m leasing reserve to cover future leasing costs; the underwriter's cashflow was US$94.4m, while Fitch assumed US$89.9m.
This past week's bickering, while not directly mentioned at the SEC roundtable, added fuel to the fire in the media as US senators urged regulators to make long-awaited changes to the "issuer pays" model which many blame for the shoddy ratings that led to the financial crisis.
Nearly three years after Dodd-Frank, Washington has still not come up with a viable alternative to the controversial compensation model.
Senator Al Franken was still pushing for his "Franken amendment", which would create an independent government board that chooses which agency rates each structured deal, but panelists from the Big Three agencies (S&P, Moody's, and Fitch) said that such a system would create conflicts of its own.
(A version of this story will appear in the May 18 issue of International Financing Review, a Thomson Reuters publication; www.ifre.com)
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