By Adam Tempkin
Oct 5 (IFR) - The decision by Standard & Poor's to change the calculation of a key credit metric has left some investors accusing the agency of watering down standards, as it seeks to rebuild its once-dominant market share in the rating of commercial mortgage-backed securities (CMBS).
S&P last month announced a set of sweeping changes to its rating methodology after a blunder last year left the company effectively frozen out of the CMBS ratings business.
But included in the changes was a reformulation of how S&P determines capitalization rates, or cap rates - a key piece of data used to determine the level of risk in a property investment.
Coming not long after the financial crisis, S&P's shift has drawn charges that it will encourage "ratings shopping", a kind of race to the bottom among the ratings agencies - each competing for business by offering improved ratings at lower costs - that set off the crisis in the first place.
"(This) just screams to me that they have to buy market share," said Nilesh Patel, a managing director at Prima Capital Advisors, an investment firm specializing in high-quality CMBS.
"It introduces a level of volatility beyond property fundamentals and beyond price," he told IFR. "This is not even a neutral development for the markets. It's a big risk."
S&P denies that the revision - which effectively assigns lower cap rates, and thus higher valuations, to the properties underlying any CMBS deal - was designed to win back market share.
It says that the new calibration is due to taking a better mix of long-term averages as well as what Gary Carrington, the agency's global criteria officer for CMBS, called "what we expect to see through normal real-estate cycles".
Carrington said that the lower cap rates would be balanced out by lower recovery projections, assumed declines in property market values, and other changes, and that the new formulas were based on cyclical historical cap rate data.
The agency also noted that the criteria changes were made only after getting feedback from more than 300 market participants. It said the overhaul - accompanied by a S&P management shakeup among its top CMBS personnel - was designed to create a more consistent set of criteria.
"S&P's cap rates and LTVs (loan to value) have always been lower than Fitch and Moody's," said Darrell Wheeler, the head of CMBS strategy at Amherst Securities.
"So that's nothing terribly new. The question is how they will monitor the transactions."
FALLEN GIANT
But the complaints about S&P's changes come at a sensitive time in the CMBS market. September saw the largest monthly CMBS issuance since 2007, before the financial crisis began, meaning S&P's absence from the market is growing more costly to the company almost by the day.
S&P, once the top player in CMBS ratings, lost its grip on the market last year after a disastrous ratings slip-up on a US$1.5bn deal led by Goldman Sachs and Citigroup.
The debacle badly eroded S&P's credibility, and left it effectively frozen out the sector. It was kept out of so-called conduits, the multiple-borrower deals that make up the majority of CMBS transactions, for more than a year.
The cap rates being reformulated by S&P are an essential tool for investors in assessing the credit risk in a CMBS transaction, in which commercial real-estate mortgages are bundled and repackaged as new investment securities.
Defined as the ratio of a property's net operating income to its total value, cap rate functions as an indicator of an investor's level of risk and return related to a property.
Rival agencies warn that while issuers and even some investors will enjoy the more lenient view of valuations in the short-term, stability and accuracy in the ratings market will be sacrificed over time.
They say S&P may be forced to change hundreds of ratings in the future if the new cap rates are overly based on current interest rates, which are close to alltime lows, or if inflation increases.
"Generally speaking, investors should always be worried," said Marc Peterson, senior CMBS portfolio manager at Principal Global Investors.
"The re-entry of S&P in the conduit market, and the possibility that rating agencies may get more aggressive, leading to ratings shopping, is definitely something to keep an eye out for. But if things get out of line, hopefully investors will be more vocal and quicker to push back on things they don't like this time around."
TIP OF THE ICEBERG?
After being shut out for more than a year, S&P was hired to rate a conduit deal for JP Morgan late last month - just weeks after the new criteria were announced.
But rival agencies Fitch, Kroll and DBRS were also chosen to rate the deal, making it the first-ever four-agency conduit - a peculiar signal that some investors saw as an effort by JP Morgan to quell concerns about S&P's presence.
Meanwhile others expressed concern that Moody's, generally considered the most conservative agency in CMBS, was not selected at all - the first time it had been left off a conduit since May 2011, according to analysts at Credit Suisse.
Spreads on the triple-B bonds widened considerably at pricing.
"This was one of the weaker deals in the market, so we didn't participate," said a New York-based CMBS portfolio manager at one of the largest insurance companies in the country.
He said he was shocked that S&P had lowered credit enhancement for lower-ranked slices versus a previous deal.
"The cap rates S&P are using may be currently supported by what we see in the market. But are they stressed sufficiently by the rating agency? Probably not," he said. "S&P is lacking the discipline exhibited by Moody's and Fitch, and even Kroll."
Two other agencies on the JP Morgan deal told IFR that S&P was not the most conservative of the raters of the transaction, which they said was unusual for an agency trying to repair its damaged image.
The average loan-to-value (LTV) that S&P assigned to the deal - 82% - was lower than that of the other three agencies by at least 14 percentage points. A lower LTV implies lower financial risk to buyers of the bonds.
S&P also graded a lower-ranking tranche in the deal at double-B, while the three others had it at single-B.
According to a pre-sale report, S&P indicated that the expected 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 to a special servicer, who takes a 25 basis point fee, and you immediately burn through that 10 basis point buffer," said an analyst at a rival ratings agency.
And at least one upgrade from S&P, carried out under the new criteria, is raising eyebrows.
The agency gave an A rating to the Class C tranche of a $340 million 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 aggressive rating, and a vote of confidence for something so far down the capital 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 Marc Carnegie)
((adam.tempkin@thomsonreuters.com; Reuters messaging: adam.tempkin.thomsonreuters.com@reuters.net))
Keywords: MARKETS CREDIT