Underwriter and Rating Agency Issues in Securitized Loan Transactions Presented to ICSC 2002 Law...

Underwriter and Rating Agency Issues in Securitized Loan Transactions

Presented to ICSC 2002 Law Conference

David W. Forti, Dechert

Michael Weinberger, Cleary Gottlieb, Steen & Hamilton

October 24, 2002

October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 2

Overview

Role of Rating Agencies What is a rating Why are ratings necessary

Rating Agency methodology CMBS rating methodology Floating rate loan and single

borrower deals


Overview

Rating Agency surveillance Post-closing surveillance of

transactions Rating actions


Role of Rating Agencies:What is a CMBS Rating

Ratings are assessments of likelihood that bond holders will receive timely payment of interest, and ultimate payment of principal by the rated final distribution date of a deal - some period of time beyond the last maturity date of loans


Role of Rating Agencies:What is a CMBS Rating

Three national statistical rating agencies routinely rate CMBS deals - Moody’s, Standard & Poor’s and Fitch. Most CMBS deals have at least 2 rating agencies

Each tranche of bonds in deal will have its own rating


Role of Rating Agencies:Investment Grade Ratings

Moody's Standard & Poor's; Fitch Description

Aaa AAA Highest rating - interestpayments protected andprincipal is secure.Expectation of payment isextremely strong.

Aa AA High quality - expectationof payment is very strong.

A A Somewhat moresusceptible to adversechange in circumstances,but expectation of paymentis strong.

Baa BBB Medium grade - investmentprotected, but adversechange could affectpayment ability.


Role of Ratings: Subordination

Real estate loans rarely possess attributes necessary to support highly rated bonds; subordination of classes of bonds is used as credit enhancement on CMBS deals

Subordination shifts risk of non-payment to more junior classes


Role of Ratings: Subordination

In evaluating deals, rating agencies determine the levels of subordination, i.e., the amount of bonds that must be subordinate to each tranche to support particular rating

Issuer’s goal is to have lowest subordination levels possible


Role of Rating Agencies: Why Are Ratings Necessary

Investment in CMBS transactions is significant source of capital for commercial real estate lending

Understanding credit risk embedded in each CMBS deal is complex and time consuming - multiple loans; each is unique


Role of Rating Agencies: Why Are Ratings Necessary

Investors in investment grade bonds often lack time and real estate expertise to do detailed analysis

Ratings provide mechanism for matching CMBS bonds with particular investor risk tolerance


Rating Agency Methodology

In evaluating deals, rating agencies do individual loan analysis and portfolio or “pool” analysis



Individual loan analysis considers credit-worthiness of individual loans, including underwritten cash flow, cash flow volatility, tenant quality, anticipated rollover, property type, quality, location and competitiveness, borrower and manager reputation, market conditions, loan structure and amortization



Portfolio analysis considers credit-worthiness of entire pool on aggregate basis, including pool size, number of and size of loans, property types, overall property quality, and concentrations, including by borrower, property type and location



In reviewing pools, rating agencies typically conduct a full file review of large loans, and a random sample of other loans


Rating Agency Methodology:Individual Loan Analysis

In evaluating individual loan, rating agencies typically re-underwrite stabilized net cash flow for collateral property, using rating agency’s criteria for determining sustainable net cash flow, which is “capped” to determine stabilized value of the property


Rating Agency Methodology:Individual Loan Analysis

Values are used to determine DSCR and LTV ratios for loan

Rating agency underwriting criteria and capitalization rates often more conservative than market



General model for determining CMBS subordination levels has 3 main components - default probability, loss severity and pool composition

Individual loans quantified using DSCR and LTV ratios to assess default probability and loss severity



May be adjusted for property/loan features likely to impact default probability or loss severity, including environmental conditions, applicable state foreclosure practice, subordinate indebtedness and presence/absence of loan provisions, such as lender-controlled cash management, escrow requirements, and bankruptcy remote borrowers



Pool composition is evaluated to determine concentrations of risk

Pool diversity (borrower, property, type, location) analyzed to determine if performance of otherwise unrelated loans may be highly correlated to one another



Pool size and loan size analyzed because small pools or pools with disproportionately large loans concentrate risk



Subordination levels can be further affected by deal structure issues, such as unusual bond structures, quality of loan representations made by depositor, and unusual PSA provisions



Once analyses complete, rating agencies determine subordination levels for pool, i.e., the aggregate amounts of bonds that will qualify for particular ratings

Some classes of bonds may be unrated, meaning that issuer has requested rating agencies not to rate those bonds


Rating Agency Methodology:Floating Rate Loans

Modeling floating rate loan pools requires evaluation of additional factors, because floating rate loans often interest only balloon loans, and may be higher leveraged short-term loans


Rating Agency Methodology:Floating Rate Loans

Interest rate risk, little or no amortization, and higher leverage increase default and loss severity probabilities, which may result in higher subordination levels

Interest rate risk can be mitigated with interest rate cap agreements


Rating Agency Methodology:Single Borrower Transactions

Evaluating single borrower CMBS transactions is similar to other CMBS transactions, except that all credit risk is concentrated in one borrower

Single borrower transactions may be a single large asset, or pool of cross-collateralized assets


Rating Agency Methodology:Single Borrower Transactions

Because no diversity in single asset deals, transactions much have extraordinary credit quality, including property quality, market position, borrower and management expertise, loan structure and leverage to support highest rated bonds


Surveillance

Surveillance is the post-closing monitoring of CMBS transactions by rating agencies

Purpose of surveillance is to ensure that ratings of bonds accurately reflect current investment risk, and provide information to investors regarding performance of CMBS deals


Surveillance

Surveillance teams monitor information provided by servicers about each deal, including review of collateral performance of large loans and statistical pool-level review of conduit loans, as well as evaluation of current pool composition and characteristics


Surveillance

Surveillance also involves review of post-closing borrower requests involving changes to loan components originally evaluated by rating agencies, including equity sponsorship, subordinate indebtedness and property management


Surveillance: Rating Actions

Bond ratings may be adjusted at any time to respond to performance trends (positive or negative) which change credit risk for a particular tranche of bonds

Affirmations of ratings occur when a transaction has performed as expected with no significant delinquencies or problems



Upgrades of ratings occur most often when there is increased credit support in a pool, though negative changes in pool composition may negate the effect of such enhancements

Downgrades of ratings generally result from actual or projected losses that are higher then originally anticipated



Within a deal each tranche is reviewed, and rating changes may affect some classes of bonds but not others

Because of subordination feature of CMBS bonds, senior bonds are most often upgraded and junior bonds are most often downgraded

Underwriter and Rating Agency Issues in Securitized Loan Transactions Presented to ICSC 2002 Law...

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