By Adam Tempkin
Oct 5 (IFR) - The decision by Standard & Poor's to changethe calculation of a key credit metric has left some investorsaccusing the agency of watering down standards, as it seeks torebuild its once-dominant market share in the rating ofcommercial mortgage-backed securities (CMBS).
S&P last month announced a set of sweeping changes to itsrating methodology after a blunder last year left the companyeffectively frozen out of the CMBS ratings business.
But included in the changes was a reformulation of how S&Pdetermines capitalization rates, or cap rates - a key piece ofdata used to determine the level of risk in a propertyinvestment.
Coming not long after the financial crisis, S&P's shift hasdrawn charges that it will encourage "ratings shopping", a kindof race to the bottom among the ratings agencies - eachcompeting for business by offering improved ratings at lowercosts - that set off the crisis in the first place.
"(This) just screams to me that they have to buy marketshare," said Nilesh Patel, a managing director at Prima CapitalAdvisors, an investment firm specializing in high-quality CMBS.
"It introduces a level of volatility beyond propertyfundamentals and beyond price," he told IFR. "This is not even aneutral development for the markets. It's a big risk."
S&P denies that the revision - which effectively assignslower cap rates, and thus higher valuations, to the propertiesunderlying any CMBS deal - was designed to win back marketshare.
It says that the new calibration is due to taking a bettermix of long-term averages as well as what Gary Carrington, theagency's global criteria officer for CMBS, called "what weexpect to see through normal real-estate cycles".
Carrington said that the lower cap rates would be balancedout by lower recovery projections, assumed declines in propertymarket values, and other changes, and that the new formulas werebased on cyclical historical cap rate data.
The agency also noted that the criteria changes were madeonly after getting feedback from more than 300 marketparticipants. It said the overhaul - accompanied by a S&Pmanagement shakeup among its top CMBS personnel - was designedto create a more consistent set of criteria.
"S&P's cap rates and LTVs (loan to value) have always beenlower than Fitch and Moody's," said Darrell Wheeler, the head ofCMBS strategy at Amherst Securities.
"So that's nothing terribly new. The question is how theywill monitor the transactions."
FALLEN GIANT
But the complaints about S&P's changes come at a sensitivetime in the CMBS market. September saw the largest monthly CMBSissuance since 2007, before the financial crisis began, meaningS&P's absence from the market is growing more costly to thecompany almost by the day.
S&P, once the top player in CMBS ratings, lost its grip onthe market last year after a disastrous ratings slip-up on aUS$1.5bn deal led by Goldman Sachs and Citigroup.
The debacle badly eroded S&P's credibility, and left iteffectively frozen out the sector. It was kept out of so-calledconduits, the multiple-borrower deals that make up the majorityof CMBS transactions, for more than a year.
The cap rates being reformulated by S&P are an essentialtool for investors in assessing the credit risk in a CMBStransaction, in which commercial real-estate mortgages arebundled and repackaged as new investment securities.
Defined as the ratio of a property's net operating income toits total value, cap rate functions as an indicator of aninvestor's level of risk and return related to a property.
Rival agencies warn that while issuers and even someinvestors will enjoy the more lenient view of valuations in theshort-term, stability and accuracy in the ratings market will besacrificed over time.
They say S&P may be forced to change hundreds of ratings inthe future if the new cap rates are overly based on currentinterest rates, which are close to alltime lows, or if inflationincreases.
"Generally speaking, investors should always be worried,"said Marc Peterson, senior CMBS portfolio manager at PrincipalGlobal Investors.
"The re-entry of S&P in the conduit market, and thepossibility that rating agencies may get more aggressive,leading to ratings shopping, is definitely something to keep aneye out for. But if things get out of line, hopefully investorswill be more vocal and quicker to push back on things they don'tlike this time around."
TIP OF THE ICEBERG?
After being shut out for more than a year, S&P was hired torate a conduit deal for JP Morgan late last month - just weeksafter the new criteria were announced.
But rival agencies Fitch, Kroll and DBRS were also chosen torate the deal, making it the first-ever four-agency conduit - apeculiar signal that some investors saw as an effort by JPMorgan to quell concerns about S&P's presence.
Meanwhile others expressed concern that Moody's, generallyconsidered the most conservative agency in CMBS, was notselected at all - the first time it had been left off a conduitsince May 2011, according to analysts at Credit Suisse.
Spreads on the triple-B bonds widened considerably atpricing.
"This was one of the weaker deals in the market, so wedidn't participate," said a New York-based CMBS portfoliomanager at one of the largest insurance companies in thecountry.
He said he was shocked that S&P had lowered creditenhancement for lower-ranked slices versus a previous deal.
"The cap rates S&P are using may be currently supported bywhat we see in the market. But are they stressed sufficiently bythe rating agency? Probably not," he said. "S&P is lacking thediscipline exhibited by Moody's and Fitch, and even Kroll."
Two other agencies on the JP Morgan deal told IFR that S&Pwas not the most conservative of the raters of the transaction,which they said was unusual for an agency trying to repair itsdamaged image.
The average loan-to-value (LTV) that S&P assigned to thedeal - 82% - was lower than that of the other three agencies byat least 14 percentage points. A lower LTV implies lowerfinancial risk to buyers of the bonds.
S&P also graded a lower-ranking tranche in the deal atdouble-B, while the three others had it at single-B.
According to a pre-sale report, S&P indicated that theexpected loss on the deal at the single-B level was only 0.1%,or 10bp - an unusually thin buffer of protection for investors.
"All it takes is for a couple of loans to be transferred toa special servicer, who takes a 25 basis point fee, and youimmediately burn through that 10 basis point buffer," said ananalyst at a rival ratings agency.
And at least one upgrade from S&P, carried out under the newcriteria, is raising eyebrows.
The agency gave an A rating to the Class C tranche of a $340million non-conduit deal in August, but then upgraded it to AA-under the new criteria just weeks later.
"While the higher ratings help me, that's an aggressiverating, and a vote of confidence for something so far down thecapital structure," said a Boston-based CMBS asset manager."You'd typically see lower ratings on that tranche."
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(Adam Tempkin is a senior IFR analyst; Editing by MarcCarnegie)
((adam.tempkin@thomsonreuters.com; Reuters messaging:adam.tempkin.thomsonreuters.com@reuters.net))
Keywords: MARKETS CREDIT