underwriter and rating agency issues in securitized loan transactions
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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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 3
Overview
Rating Agency surveillance Post-closing surveillance of
transactions Rating actions
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 4
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 5
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 6
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.
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 7
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 8
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 9
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 10
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 11
Rating Agency Methodology
In evaluating deals, rating agencies do individual loan analysis and portfolio or “pool” analysis
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 12
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 13
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 14
Rating Agency Methodology
In reviewing pools, rating agencies typically conduct a full file review of large loans, and a random sample of other loans
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 15
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 16
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 17
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 18
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 19
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 20
Rating Agency Methodology
Pool size and loan size analyzed because small pools or pools with disproportionately large loans concentrate risk
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 21
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 22
Rating Agency Methodology
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 23
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 24
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 25
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 26
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 27
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 28
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 29
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 30
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 31
Surveillance: Rating Actions
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
October 24, 2002Underwriter and Rating Agency Issues in Securitized Loan Transactions 32
Surveillance: Rating Actions
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
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