Many Commercial Mortgage-Backed Securities received inflated ratings from rating agencies due to the phenomenon of “ratings shopping.”
By Marc Joffe, a Federalism and State Policy Analyst at the Cato Institute, for WOLF STREET:
Despite surprising economic strength and the end of pandemic emergencies, American shopping malls continue to struggle. Among the mall-based retailers announcing store closures in 2023 are Macy’s, Bed Bath and Beyond, and JoAnn’s. Meanwhile, Party City, Tuesday Morning, and Regal Cinemas have both filed for bankruptcy protection and are closing many of their locations. Continued high interest rates are putting pressure on commercial real estate valuations, making it even harder for mall owners to refinance mortgages as they mature.
These developments are bad for commercial real estate lending and commercial mortgage-backed securities (CMBS) held by institutional investors including mutual funds. Many of these securities received inflated ratings from rating agencies in the 2010s due, in part, to a phenomenon known as ratings shopping. With upwards of six SEC-licensed Nationally Recognized Statistical Rating Organizations (NRSROs) competing for business from bond underwriters, the pressure to dumb down credit standards appears to have been too much in some cases.
One type of overrated CMBS deal I have previously highlighted on Wolf Street is the Single Asset Single Borrower (SASB) variety. Unlike traditional (or “conduit”) CMBS. SASB CMBS deals have little or no diversification. A SASB deal can produce large investor losses if even one shopping mall becomes distressed, because that mall represents all or a large proportion of the loan collateral.
This is the case with a CMBS deal named GSMS 2012-BWTR, backed solely by a mortgage on Bridgewater Commons Mall in Bridgewater, NJ. The senior bonds in this deal received top ratings from Moody’s and Kroll Bond Rating Agency in 2012. But ten years later the mall owner declined to make the $300 million balloon payment at the ten-year loan maturity on December 1, 2022, leaving creditors with the decision about whether to foreclose.
Moody’s has downgraded the Class A bonds just two notches to Aa2, while Kroll has a more realistic assessment of BBB- which is nine notches below its highest rating. According to Empirasign, the bonds were recently valued at around 88 cents on the dollar suggesting that evaluators are expecting a principal loss.
One might think that a principal default on the only loan in a CMBS deal would cause rating agencies to immediately downgrade all securities in that deal to the lowest possible rating. But there’s a catch. Even though the underlying loan has a ten-year maturity period, the CMBS bonds are rated based on a “legal final maturity date” in 2034. As long as the bonds continue to pay interest (which the mall’s owner is still covering) and the principal can be recovered by 2034, the bonds are not considered to be in default from a ratings perspective. Investors who were expecting to be paid off in 2022 might look at it differently.
Starwood Retail Portfolio SPRT 2014-STAR Class A experienced a default and S&P withdrew all its ratings on the deal. This appears to have been the first payment default by an initially top rated senior SASB CMBS security. The formerly AAA-rated bonds were recently marked at 68.
Destiny USA (Syracuse, NY) bonds appeared to avoid a similar fate last summer, when the mall’s owner, Pyramid Companies, secured a five-year extension to the mall’s two mortgages. However, the extension came with a reduced interest rate, and the mortgage interest has been insufficient to fully cover interest obligations to senior bondholders, let alone the subordinate bondholders. As a result, S&P downgraded JPMCC-2014-DSTY to “D” in December 2022, marking the second AAA SASB CMBS default. Empirasign shows a recent value of 46.5.
The next AAA bond on the cusp of default relates to the securitization of another Pyramid Companies mortgage, this one for the Palisades Center Mall in West Nyack, NY. The mall is now in foreclosure and its recent assessed valuation of $217 million is below the amount of senior bonds outstanding. PCT 2016-PLSD Class A bonds most recently carried an S&P Rating of B-and a Moody’s rating of B2, both well below investment grade and are valued around 78. Although the mall has strong anchor stores, it also houses a 21-screen AMC Theatre, making it vulnerable to ongoing weakness in the cinema business.
Other mall based CMBS have fared marginally better. A third Pyramid Companies mall, Walden Galleria in Buffalo, NY received a three-year mortgage extension in June 2022 when principal became due. The loan still seems to be collecting enough interest to satisfy senior bondholders, whose securities are rated BB- by S&P and were recently valued around 81.
Two bonds are holding onto investment grade ratings. BBSG 2016-MRP Class A, secured by a mortgage on The Mall at Rockingham Park, in Salem, NH has an S&P rating of A- and a recent value of 86. GSMS 2018-SRP5, backed by a mortgage on five malls in three states, is now rated BBB- and valued at 84. Although these two bonds have thus far avoided downgrades into speculative grade territory, their owners probably did not expect to take a roughly 15% value haircut when they acquired these supposedly gilt-edge securities.
With so many mall backed SASB CMBS from the 2010s performing poorly, one might expect rating agencies and investors to shy away from this asset class. And yet, at least eight additional deals launched in 2021 and early 2022. By Marc Joffe.
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