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.
In addition to the news about the Bridgewater Commons loan, I have a few updates on other distressed CMBS that I previously covered here at Wolf Street or in National Review’s Capital Matters.
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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1) Home buyers in the Bay area used their stocks and stock options as a
collateral to buy their $1M- $5M homes.
2) Their collateral is severely underwater. The banks own zombie homes. Their assets are intact, no harm was done.
They will sell these homes after NDX complete it’s rd trip to Feb 2020 high and bounce back up to a lower highs.
3) The banks will cash in, cut their losses, or take profit and jump ship,
because the Fed is fed up with these banks with their impaired RE and car loans.
4) A tsunami of homes for sales will flood Seattle and SF, joining the impaired commercial RE.
5) CA bonk !
Go NDX to Feb 2020 high and save the banks !
In my East Bay suburb, a modern three story office building is having major maintenance problems. Some windows are boarded up and the HVAC has been making loud noises for several months. I don’t know if the building owners are in default of their mortgage but it does not look good. I don’t know what the occupancy of the building is, but low occupancy appears to be a problem even among some suburban office buildings.
Luckily, I diversified my investments into the Ponzi Companies also.
“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.”
Lol. “Pyramid” is an an ironic name under the circumstances.
Thank you for the article. I realize these deals are from 2010, but is “ratings shopping” still a common practice? It should have been banned somehow after the disastrous ratings leading to the GFC.
I am afraid it is still a problem. Morningstar and DBRS have merged, leaving only five rating agencies competing in the CMBS market instead of six, but that is still a lot. One way to compete for business is to “dumb down” credit standards.
Thank you. Dumbing down standards to compete for business seems like such an obvious problem it would eventually be addressed. I guess it’s up to bond buyers to hold the agencies responsible by ignoring ratings from agencies that dumb down their standards the most.
One alternative to the conflicted rating agencies’ (mostly) “black box” evaluation processes, would be to simply rely upon a number of “open source” formulas that use publicly available numbers (Z-scores, etc).
Since the rating agencies have repeatedly and spectacularly failed (and failed to be held accountable by the mkt), it isn’t like a lot would be lost. It isn’t like the agencies have *any* financial skin in their game…and they ultimately disclaim liability in their publications…so what are they really selling?
Presumably the buy side goes along with the farce due to CYA reasons.
LOL! Exactly my response when I read this! You can’t make this stuff up!
rojogrande,
“these deals are from 2010”
Maybe just a typo. But to be clear, Marc Joffe, the author, said: “2010s” — so that’s the decade of 2010-2019 and not the year 2010.
I’m not sure any of these deals are from 2010, that was kind of a bad year for issuing CMBS, LOL
Thanks I didn’t catch that. I thought 2010 might be before any reforms were enacted in the wake of the GFC, which prompted my original question about ratings shopping. It’s too bad the practice continues.
The deals I covered were launched between 2012 and 2018. The year of issuance is included in the name of each deal.
Because Trapezoid Companies was already taken, as was Tetrahedron Companies.
I’m invested in Rega’s ‘Line Contact’ as my primary generating source. But for diversity, I also have two shares of Audio Technica’s ‘Micro Line’ which can also create streams of energy for use when needed.
I still think it’s funny that Powell praises the last several decades as an epic time of financial innovation.
In macro terms, it might be instructive to quantify the amount of economic damage, caused by mortgage backed securities, even more funny, to determine the actual value of the cost the Fed pays to hold onto their stockpile of toxic waste.
In micro terms, related to strip malls, one wonders about the future profitability of karate studios and bail salons, but in actuality, those micro businesses are all run better than any MBS portfolio!!!!!
Something, something about negative convexity, blah, blah…
Along those lines, what jumped out to me from Mr. Joffe’s report was Single Asset Single Borrower securities.
It makes sense to minimize risk by putting together a large number mortgages and package them up, although it does invite a whole host of problems. But to have a deal with one mortgage, Bridgewater Commons Mall for example, and split it up as a “Security” is nothing more than buying a piece of one mortgage.
Shakespeare once remarked, “A rose by any other name would smell as risky.”
Well, single-asset securitizations are *not entirely* useless (due to lack of diversification).
What they do is carve up different investable tranches, with distinct risk/return profiles – so that one asset can have a AAA tranche and a BBB tranche (and so on).
That is accomplished by directing repayment cashflows preferentially to the higher rated tranches.
If a repayment shortfall occurs, the lower tranches usually take the entire loss…first (first loss position…shielding the higher tranches).
Arguably there is some value in this slicing of risk.
Yes the senior tranche should be rated higher than the subordinate ones, but never AAA without diversification.
Marc,
I agree, I just don’t know all the bizarro crap debt out there after 20 yrs of the Fed murdering interest rates (driving investors to dangerous madness in a search for yield…any yield)
Cas & Marc,
I guess, understanding these single-asset securities is above my pay grade.
So, a mortgage on an individual commercial property, which I assumed was one contract with a balance and a payment schedule, can be carved up into different “investable tranches?”
One thing about Wolf Street; you learn something new every day.
Thank you for the report Marc.
Prairie Rider,
The “tranches” (or “tiers”) of a CMBS determine and structure who takes the first losses. For example, in a single-asset CMBS, backed by just one big mortgage: Assume the owner of the property defaults on the mortgage, and the servicer (the representative, if you will, of the holders of the CMBS) forecloses on the property, and sells the property at a price that covers 50% of the mortgage. So the tiers of the CMBS take that loss in sequence. The lowest rated tiers get wiped out (100% loss), a mid-tier might have a 50% loss, and the top-rated tranche might have no loss.
A lot of times, the bottom tiers, the lowest rated tiers, are small and cannot absorb large losses. The biggest tiers are at the top, and because the bottom tiers are too small, the losses spread to the top tiers. These CMBS were not designed for a 50% loss.
Note that some of the foreclosure sales of office buildings that I covered dished out losses in the 85% range, and the losses spread all the way up.
This is why the lowest-rated tiers pay the highest yield, and the top-rated tiers the lowest yield. Investors choose the risk they want to take, and earn more or less yield, depending on that risk the chose to take.
Thank you for the explanation Wolf. That certainly makes sense to me now.
Bail salon? Where you can get a manicure and a bail bond at the same time? Lol
Yep having experienced a good 200k of Lehman CMBD defaults in 2008 due to my ignorance and of course the banking MBS debacle . My opinion is we have very little oversight regulatory wise on the products brought to the public which can be witnessed by the epic SPAC and IPO companies highlighted in Wolfs plunging stock price list
Oh good… a guest author. We haven’t had one in a while at WolfStreet. I always learn so much from them.
This is similar to what is happening in China: while sales are down dramatically because people there have figured out that real estate prices will not go up more and prices would decline (if the government ceased its not so covert manipulation efforts), prices are TEMPORARILY being held up by the CCP. So expect RE prices to ultimately crash after the little Dutch boy (the CCP) must take his finger out of the hole in the dam. LOL
Hello from China, where I have lived for over 10 years.
Real prices have been collapsing for about 3 years, even in the Tier-1’s. But nobody is really allowed to sell at lower prices, so the market is essentially frozen. It’s the weirdest thing to see in economics. And it does make you wonder how much better off the country would have been, were it not for untold trillions and trillions of dollars of malinvestment in RE.
China can slow new real estate development so that the real estate supply glut is reduced over the next few years.
But where, then do all the captive savings go? More shadow bank loans?
What will China do to keep all of the workers in various areas of real estate development employed while the supply gut eases? I imagine the transition will be very difficult which is why it was allowed to get so out of control.
The raised probability of a looming recession becoming factual, along with the unfortunate war posturing among the nuclear powerhouses, does not bode well for RE in general, the stock market and especially those failing malls.
People will be tightening their purse strings as inflation gets out of hand. The big downturn appears inevitable after churning false hope for a soft landing for a year or more.
Nuclear war should not be an option, but they certainly push the envelolpe. Pray not! May more sensible leaders lead.
Despite all this “economy is running hot” talk, I see lots of companies pulling in their horns, culling workers, cutting dividends, conserving cash. They seem nervous.
I was curious about why the huge push to end WFH and ended up finding a 2020 paper from McKinsey about who owns wealth, and corporations have a significant amount of their assets in real estate. That real estate is used as collateral for operational loans. If that valuation goes down their flow of cash in and out gets tight, or more expensive to use. Which I guess if you’re a corporation is probably bad.
Those assets are performing poorly at a time when retail sales continue to be very strong…what happens when we fall into recession? what happens when the Fed has sold off 2 trillion from the balance sheet?
this is a big house of cards and it needs to all fall apart, so we can get to a place where money means something.
“Sensible Leaders” seems to be an oxymoron today.
Shopping malls are starting to fade away, a bit like the Fotomats of the 1970s.
I was just reading about Florida real estate and little issues like their property insurance being 4x national average.
It’s becoming increasingly clear that it’s officially time to become afraid of all these economic issues, including stupid funding for pointless shopping excess. Commercial real estate is going to eventually be an epicenter for cash starvation.
It’s jaw dropping how much crap is happening…
“In a soon-to-be-released report …Cushman & Wakefield PLC is projecting that the U.S. will end the decade with a record 1.1 billion square feet of vacant space, compared with 688 million square feet in 2019”
Great report BTW
The Cushman & Wakefield report is about office space, not retail. Office is arguably in far worse shape than retail, though the problems just started a couple of years ago, which retail has been hemorrhaging since about 2015 when retailers started going bankrupt. And office involves companies with lots of money, not struggling retailers, so it’s going to look different.
I think a pretty good argument can be made that on a macro level, crap loans are the necessary result of phony, unbacked fiat being injected nationally/globally.
1) If “new, multiplier money” floods into the macroeconomy without a parallel increase in real assets…there are only a few places it can possibly go…and a big one is for it to be layered on top of investable assets that pre-QE were much lower valued (result…overvaluation destined to implode).
2) This dynamic also manifests in the gutting of interest rates by ZIRP (via QE)…as “safe asset” returns go to zero…riskier/doomed assets get subsidized as dollar holders desperately hunt for yield (that is how you get 4% rates for junk bonds in 2018, when riskless Treasuries yielded 5%+ in the late 90’s!!).
It is almost like the Fed was working for the incineration of savings via overvaluation.
I appreciate this article. The ratings game has been highly competitive. The competition isn’t over: One agency revised standards last year to win back more market share. When AAA bonds take losses, the process has obviously failed.
But, look, this can’t just be laid at the feet of rating agencies. Buyers should have known that no amount of credit enhancement can make up for bad collateral. Single property deals are the most straightforward to underwrite. These were all bought by sophisticated institutional investors (SASB bonds are 144A securities). These investors all claimed to do their own property-level underwriting and they had well paid analysts and PMs working on it.
Blame the Fed for forcing everyone out the risk curve. The mall-backed bonds were some of the highest yielding options on the table. If you had known at the time that the Fed was going to bail out all of corporate America in 2020 with super-low rates and direct QE for corporate debt, then you would have opted for the riskiest high yield debt instead. The government picked winners and losers, and these assets were in the second catagory.
Thanks for the well informed comment. When I have looked into CMBS before I noticed that they offer higher spreads at any given rating. So if an investor is constrained by the fund’s investment policy to stay above a certain rating, he or she might like CMBS to juice up returns. If that’s the case, maybe investors are in on the game. Does that make sense?
How could shopping malls be anything BUT distressed. It’s an outdated business model. Driving, parking, dealing with crowds, high prices and limited choices.
The pandemic and work from home should have been the investor wake up call to sell sell sell.
I hope that the owners of these shopping malls change them fundamentally in order to attract more shoppers.
It may mean adding new services, features and attractions which will motivate people to shop there.
The nature of shoppers (20 years to 40 years) has changed a lot over the last 20 years mainly due to online shopping.
Agreed. My last trip to Palisades with my young kids in tow made me realize, its SO much easier to shop Walmart/Target/online than park in a ginormous, mostly empty, parking garage/lot and trek miles through a 5-odd story mostly empty mega mall to find the few remaining stores and attractions of interest.
There’s literally nothing to see but empty boarded up shops for 5+ minutes walking at a time. With modern attention spans measuring in nano seconds, and general aversion to long walks, its hard to bring people back. Especially when one can’t help but remember the mall in its prime and the fun once had there, quite depressing to go now.
‘They’ will certainly need to make these spaces useful in present day terms. The way suburban NYC is, I will not be surprised to see the Nyack mall (or its footprint) turn into residential luxury multifamily housing and medical facilities if they haven’t started this already.
Thanks for these details Lili. I last visited this mall in 2000 and recall it being fully leased and very vibrant. You have now updated my mental image, and your observations help explain why the appraised value is so much lower.
The sheer greed of the shopping mall operators has destroyed what was once useful.
In the 1970’s, you went to the mall because it was a single place you could go to get EVERYTHING you wanted…true department stores like Sears and Montgomery Ward carried a tremendous range of products. There was a significant diversity in the products sold by the smaller stores.
Even in the 1990’s, my visits to the mall were driven by going to specific stores that no longer exist (B. Dalton, Waldenbooks, Radio Shack, Suncoast Video, Sears).
As mall rents have gone up, only the stores with the highest profit margins remain, resulting in a retail monoculture of clothing stores with massively overpriced offerings.
Go to the mall and look around. How many of the people you see are wearing the clothing sold in the mall? How many of them are wearing the cheaper attire sold in Walmart and Target?
The malls are all chasing the steadily dwindling supply of people with large amounts of disposable income. Even in the most affluent zipcodes, it’s not working. A few years back, I visited the Natick Mall in Natick, MA. The mall is in the middle of a region of multi-million-dollar houses. It has an entire wing devoted to hyper-expensive jewelry and designer stores. On a Saturday afternoon with beautiful weather, I only saw a half-dozen people in that wing during the 30 minutes I was there. The store employees outnumbered the customers by about 5 to 1, and they looked seriously bored.
On the opposite extreme, I’ve also visited the Southern Hills Mall in Sioux City, IA. Only about 20% leased, with only two anchor tenants remaining. It was also a ghost town in terms of customer traffic. The only exception to the clothing monoculture was a Barnes & Noble book store.
Palisades Mall in Nyack has been in decline for years. Nothing like it was back in the early 00’s. Last I was in there was a year or two before the pandemic. Whole floors devoid of retail, most of the cool restaurants and attractions gone. Food Court used to have actual decent and unique food, but by 2020, nope. Its basically Target and Home Depot keeping it alive. Was not surprised to read it was on the brink of bankruptcy yesterday, shame for the town that depends on it for tax revenue. That mall was hugely popular throughout the 00’s, its build made it the largest mall on the East Coast at the time if memory serves me. Just crazy to see that massive mall now mostly empty.
American communites were once rural, so shopping was limited. Towns solved shopping as shops could be accessed in one small area. As “towns” grew and spread, so did stores. Travel from one to another or across town became a time consumer. Up pops the idea of “malls” where you could once again go to one place and get pretty much whatever you needed or wanted. Enter the internet shopping. Began to cut into mall traffic, as did the gangs and other miscreants roaming malls looking for trouble. Now even big retailers are cutting back on stock in favor of “ship to store” or “ship to you”. Inventories are getting smaller and smaller to the point now of why bother store shopping, what I want won’t be there anyway. Malls are just the road kill along the highway of change. They were cool while they lasted.
Great insight as always.
Regarding Destiny Mall, Syracuse.com reported last May
that the mall had an appraised value of $139 million against $715 million in debt.
“J.P. Morgan Chase Bank wrote the loans — one for $300 million and the other for $130 million — in June 2014 and later sold them on Wall Street as commercial mortgage-backed securities.
Overall, Pyramid owes approximately $715 million on the mall — the $430 million in mortgage loans, plus $285 million to the buyers of bonds issued by the city’s industrial development agency.
Yet the mall is worth far less.
An appraisal done in 2021 for lenders placed its value at $203 million. But Kroll Bond Rating Agency estimated in a March 25 report that the present value of the mall was just $139.2 million.”
The article went on to say that the CMBS are subordinate to the bonds.
Thanks for the color on Destiny USA. I was surprised to see the mortgage extension last June, but maybe it made sense on some level. Since the senior pilot bond is greater than the mall’s value, it may be better for the CMBS bondholders to continue receiving some interest rather than foreclosing and ending up with a zero recovery.
Seems those who raise, deploy and invest capital for grand projects have been snookered; malls so large that time has run out to service the debt. Of course these great enterprises employed many people to build and maintain and helped defray residential property taxes over this time so much good was accomplished. But what comes next?
Where I live in New England the many small brick factories closed when industries moved south and west to escape unions and high taxes. Last week I visited a packed 70,000 sq ft factory re-purposed as a Mongers Market, open only one day a week. Booths are rented by folks who have collected scrap articles, parts of machinery, industrial and architectural salvage and equipment circa 1800’s – 1960 being sold as tables, curios and such. I wondered how many people who are working from home and not commuting have found time for such unique side hustles.
While I’m here, has anybody wondered if there are too many microbreweries being opened up?