Commercial mortgage-backed securities(CMBS) collateralized by floating rate loans(floaters) have become an important part ofthe CMBS market. Because they typicallyhave low prepayment penalties and shortlock-out periods, floaters have generallyappealed to borrowers with transitional assetsor short-term holding horizons. However,based on their interest rate expectations,some conduit borrowers may opt for floatersas a flexible financing alternative that willprovide them with the opportunity to refi-nance in a more favorable interest rateenvironment.

Moody’s approach to rating floating rateCMBS transactions shares the same method-ology as that used for fixed-rate CMBS, exceptfor an additional step necessary to assess thecredit risk associated with floating interest rates.First, Moody’s reviews the collateral perfor-mance and determines stabilized cash flows.A fixed-rate-based baseline credit enhance-ment is derived using Moody’s debt servicecoverage ratio (DSCR), loan to value (LTV)ratio and asset quality grade. In the next step,interest rates are stressed to determine thecredit enhancement adjustment necessary tocompensate for floating rate risk. This adjust-ment incorporates the impacts of bothpotentially higher interest advancing costsand additional term defaults associated withthe interest payment volatility.1 The defaultfrequency at balloon is the same for bothfixed-rate and floating rate CMBS. Thisadjustment is further calibrated to reflect thejoint probability of simultaneous interest rateand real estate stresses. As in the fixed-rateCMBS rating methodology, the final stepconsists of portfolio adjustments for elementssuch as diversity, structural characteristics andquality of underwriting.

MARKET DRIVERSThe CMBS market currently offers commer-cial real estate borrowers two primaryfinancing alternatives: long-term fixed-rateand short-term floating rate loans.2 Long-termfixed-rate loans typically have ten-year terms,20-year to 30-year amortization schedulesand strong call protection.3 This level ofprepayment protection provides investorsmore certainty in cash flows and has helpedmake the current CMBS interest only (IO)market viable.

Long-term fixed-rate financing typically suitsthe needs of long-term borrowers with stabi-lized assets. On the other hand, floating ratefinancing is more attractive to borrowers thatrequire prepayment and refinancing flexi-bility due to the transitional nature of the realestate asset or the borrower’s expected shortholding period. In addition, traditionalconduit borrowers with stabilized assets mayalso consider floating rate loans. Theseborrowers anticipate that interest rates willdecline at some point over the next few years,at which time they will prepay their loansand lock in more favorable fixed-ratefinancing.4

A CMBS floating rate loan typically has atwo-year to five-year term and provides for aone-year or two-year contractual extension.The prepayment penalties are less onerousthan their fixed-rate counterpart and mayinclude a short lock-out period followed by astepping down percentage penalty, asopposed to the potentially very expensiveprepayment costs associated with yield main-tenance and defeasance. Floaters are ofteninterest only loans, so the initial coverage istypically higher than for equivalent amor-tizing fixed-rate loans.

CMBS: Moody’s Approach to RatingFloating Rate Transactions

John Junyu Chen andMilton Chacon

Chen

Chacon

7summer 2000

The Impact of Floating Interest Rate onExpected LossMoody’s analysis of the credit impact of floating rateloans is based on the expected loss concept, which incor-porates both default frequency and loss severity. Thefrequency of default during the loan term is generallydetermined by the borrower’s ability to make debtservice payments based on the property’s cash flow.Either a decline in property cash flow or an increase indebt service can increase term default frequency. Balloondefault frequency depends on the interest rate environ-ment and balloon balance at the time the loan matures.If the balloon balances are the same, both floating andfixed-rate loans bear the same refinancing risk.

The loss severity represents realized losses on a CMBScollateral pool, and servicer advancing of default interestis assumed. Therefore, the loss severity has three majorcomponents: property value losses, workout costs, andadvancing costs. Property value losses result fromdeclines in the property values below the outstandingloan amounts, due to either reduced cash flows or risingcapitalization rates. Workout costs include specialservicing fees, legal costs and other third party fees.Advancing costs result from the servicer’s obligation toadvance unpaid debt service on defaulted loans.10 Uponfinal disposition of the defaulted asset, the servicer isreimbursed all advanced debt service and interestthereon, before any principal distributions are made tothe certificate holders. Higher interest advances henceresult in higher realized losses to the trust.

The incremental credit impact of interest rate volatilityon floating rate loans as compared to fixed-rate loans,assuming no interest rate caps, can be broken into defaultfrequency and loss severity components, as shown inChart 2 and summarized as follows:

• Default Frequency: The floating interest rate has noimpact on balloon default frequency since both fixedand floating rate loans will face the same refinanceenvironment. However, it could affect the term

default frequency because rising interest rates maycause additional defaults during the loan term due tothe mismatch between stable property cash flows andrising debt service.11 The probability of floating rate-induced additional term defaults depends on thestressed interest rate as well as the capacity of theproperty’s cash flow to absorb rising debt service.Such capacity is reflected in the loan’s break-eveninterest rate.12

• Loss Severity: For loans that would have defaultedunder the related fixed-rate stress scenario, theseverity of loss associated with property value lossesand workout costs for these defaults are assumed to beunaffected by the floating rate. However, interestadvancing costs will be higher if interest rates riseduring the related workout period when a floating rateloan defaults, as the advancing rate is based on thethen current interest rate. In contrast, after a fixed-rateloan defaults, the servicer is required to advanceinterest payments at the stated fixed-rate to theCMBS certificate holders. The additional advancingcosts, if any, are deducted from the final liquidationproceeds, resulting in a higher loss severity in theevent of default. For loans that default during the termdue to the floating rate feature, i.e. potentially higherinterest payments, the loss severity is expected to belower than defaults caused by changes in real estatevalues. The losses on additional term defaults causedby interest rate volatility come primarily fromworkout and advancing costs.

Joint Interest Rate and Real Estate StressMoody’s has further considered the likelihood of bothreal estate and interest rate stress occurring simultane-ously. For example, arguments can be made that a severereal estate recession would typically be associated with asevere general demand contraction, during which periodinterest rates would be unlikely to rise to a high stresslevel. However, it would not be unlikely that a higherinterest rate environment could coincide with a property

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

9summer 2000

Chart 2: The Incremental Impact of Floating Interest Rates on CMBS

Default Frequency x Loss Severity = Credit Loss

No impact; floating andfixed-rate loans havethe same refinance riskat balloon

Higher; floating rate loans may incuradditional interestadvancing costs.

Higher; floating rateloans have higher termdefault frequency due to interest rate volatility.

Severity depends onwhether a default isreal estate or interestrate related

Higher; potentiallyhigher term defaultfrequency and greaterloss severity due tohigher interestadvancing costs

Balloon Defaults

Term Defaults

market downturn. Moody’s believes that the floating rateadjustment should not be a pure addition to the baselinecredit enhancement, therefore a joint probability factoris applied to the floating rate adjustment to reflect thepossibility of both real estate and interest rate stress notoccurring during the same period.13

CALCULATING THE FLOATING RATECREDIT ENHANCEMENT ADJUSTMENTMoody’s has developed a CMBS floating rate approachto quantify the credit enhancement adjustment neces-sary to compensate for the floating rate risk. Theapproach incorporates loan specific inputs such as termto maturity, terms of borrower extension options, DSCRand LTV ratios, spread over LIBOR and the strike rate ofthe interest rate cap if one exists. This loan specific infor-mation, together with the stressed interest rateassumptions discussed above, is used to calculate anadjustment for each rated class of securities.

To illustrate our approach, we have selected threesample floating rate loans representing different levels ofleverage with Moody’s LTVs of 65%, 85% and 95%.Chart 3 presents the calculation of floating rate creditenhancement adjustments for these three loans. In thisexample, the calculation is focused on the Aa2 class,however the same methodology applies to other ratedtranches by varying the levels of interest rate stresstogether with incremental default frequencies and addi-tional advancing costs.

The following is a step by step explanation of the proce-dure for calculating the floating rate credit enhancementadjustment for a loan with a Moody’s LTV of 85%, asshown in Chart 3. The same procedure applies to theother two loans as well. The loan is assumed to have athree-year term plus a one-year extension, a spread of 2%over LIBOR, and no interest rate cap. For this example,the stressed interest rate for the Aa2 rating level is14.25%, the sum of the stressed LIBOR of 12.25% andthe spread of 2%. The breakeven interest rate is calcu-lated by dividing the property’s net cash flow by the loanamount. There are four steps involved in the calculationof floating rate credit enhancement adjustment:

• Step 1: Evaluate baseline default frequency. UsingMoody’s fixed-rate rating methodology, assume that 22points of credit enhancement are deemed necessary foran Aa2 rating, prior to considering floating rate risk.This credit enhancement considers a 55% defaultfrequency and a 40% loss severity.

• Step 2: Calculate additional loss severity. For the base-line default frequency (55%), additional loss severityoccurring due to increased interest advancing costsneeds to be determined. The additional advancing rateper year is calculated as the difference betweenMoody’s hurdle rate of 9.25% and the Aa2 stressedinterest rate of 14.25%, or 5%. Allowing for an averageworkout period of 1.5 years, the total additionaladvancing costs would represent an incremental loss inthe event of default of 7.5% (1.5 years x 5%). The

10 CMBSWORLD

Chart 3: Example of Calculating an Aa2 Floating Rate Credit Enhancement Adjustment

Loan (1) Loan (2) Loan (3)

Moody’s LTV 65% 85% 95%Breakeven mortgage rate 15.38% 11.76% 10.53%Stressed interest rate for an Aa2 rating 14.25% 14.25% 14.25%

Step 1: Base case analysis (based on fixed-rate)Aa2 default frequency 35% 55% 90%

Step 2: Additional Loss Severity due to floating rateAnnual additional interest advancing costs 5.0% 5.0% 5.0%Total additional interest advancing costs (1.5 years) 7.5% 7.5% 7.5%Credit loss due to additional advancing costs 2.6% 4.1% 6.8%

Step 3: Additional Term Defaults due to floating rateAdditional term default frequency 12% 22% 10%Loss severity of interest related defaults 16% 20% 24%Credit loss due to additional term defaults 1.9% 4.4% 2.4%

Step 4: Credit Enhancement Adjustment Aggregate Additional Credit Loss 4.5% 8.5% 9.2%Joint Stress Probability 65% 65% 65%

Floating Rate Credit Enhancement Adjustment 2.9% 5.5% 6.0%

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

product of 7.5% (additional advancing costs) and the55% (baseline default frequency for Aa2) results inapproximately 4.1 points of additional credit loss atthe Aa2 rating.

• Step 3: Estimate additional term defaults.As a result ofinterest rate stress for an Aa2 rating, an additional termdefault frequency of 22% is estimated based on thelikelihood of the breakeven mortgage rate being lowerthan the stressed interest rate, bringing the total defaultfrequency to 77% (55% + 22%). This estimateconsiders the option value for borrowers not to defaultimmediately when the stressed interest rate exceedsthe breakeven rate, as well as the probability distribu-tion of future property cash flows. The loss severity forthe additional term defaults is primarily due toworkout and interest advancing costs, estimated at20%. Therefore, the additional credit loss from addi-tional term defaults is 4.4 points (22% x 20%).14

• Step 4: Determine floating rate credit enhancementadjustment. Based on step 2 and step 3, the aggregatecredit loss is 8.5%. (4.1% + 4.4%). However, thechance of an extreme interest rate environment and asevere real estate recession occurring simultaneously isnot very high. Therefore at an Aa2 rating level, a 65%joint stress probability is applied to the floating rate-related credit loss of 8.5%, resulting in the final floatingrate credit enhancement adjustment of 5.5 points(65% x 8.5%).

Chart 3 also presents the calculation for the other twoloans with low and high leverage. The floating rateadjustment is lower for the low leverage loan (2.9%) andhigher for the high leverage loan (6.0%). Note that theadditional term default frequency for the high leverageloan is capped at 10% because the baseline stresseddefault frequency is already 90%.

In general, the floating rate credit enhancement adjust-ments have the following characteristics:

• The floating rate credit enhancement adjustmentincreases with leverage, everything else being equal. Forexample, an investment grade loan may have a floatingrate adjustment that is only half of the adjustmentrequired for a loan with conduit-type leverage. Thisdifference in the penalty reflects the capacity of theinvestment grade loan to absorb higher interest rateincreases during the term without causing a loan default.

• The floating rate penalty levels off at a Moody’sleverage of 95% to 100%. At the high rating levels,most of the highly leveraged loans in the pool arealready assumed to default even under our fixed-ratestress scenarios, therefore the floating rate penaltyconsists mostly of the increased advancing costsresulting from stressed interest rate scenarios.

• The floating rate credit enhancement adjustment ishigher for loans with longer terms to maturity, inclu-sive of contractual extensions. All contractualextensions are assumed to be exercised in our analysis.Higher interest rate assumptions are used for longer-term loans to reflect the increased uncertainty aboutinterest rate levels over a longer horizon.

• Floating rate loans are often interest only. Additionalcredit enhancement may be necessary due to the lackof loan amortization, in addition to the floating ratecredit enhancement adjustments.

INTEREST RATE CAPSThe above example illustrates the floating rate creditenhancement adjustment with no interest rate caps.Often, borrowers are required by lenders to purchaseinterest rate caps to mitigate rate volatility during theloan term. An interest rate cap has two primary creditbenefits: (1) reducing the additional default frequencyduring the term, and (2) reducing the interest paymentshortfall, until the cap expires, for loans that do defaultduring the term. Moody’s prefers that the cap issuer berated at least Aa2 to receive the full benefit for theinterest rate cap.

Timing of DefaultsTo determine the benefit of a cap, it is necessary toconsider the timing of defaults. Lower leverage loans willgenerally take longer to default since the likelihood ofshort-term credit deterioration is lower, and shorter termloans will tend to have more defaults closer to theballoon date. Chart 4 presents an illustration for a loanwith a 3-year term. Assume that an all-in interest ratecap with a strike rate of 9.25% is purchased for the loanterm, and that on average it will take 18 months to workout a defaulted loan. Should interest rates rise shortlyafter the loan is originated, and the all-in rate for thesample loan becomes higher than 9.25% for the next fiveyears, there are three possible scenarios for the timing ofdefault and the related advancing costs.

• Scenario 1: The loan defaults at the end of the firstyear and is being worked out while the cap is still ineffect. The loan experiences no advancing costs inexcess of the 9.25% hurdle rate, because the interestrate cap effectively removed all incrementaladvancing costs due to interest rate increase. As aresult, like a fixed-rate loan, there is no incrementalloss exposure for this loan.

• Scenario 2: The loan defaults at the end of the secondyear of the term. The cap prevents incrementaladvancing costs during the third year of the loan termwhen the loan is being worked out. However, duringthe last six months of the workout period the servicer

11summer 2000

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

defaults. Furthermore, during the workout periodfloating rate bonds may incur higher losses due to poten-tially higher interest advancing costs. In general, higherleveraged loans, as indicated by Moody’s LTV ratios,require more credit enhancement as there is less oppor-tunity for the equity position to help absorb the interestpayment risk.As leverage becomes very high, the floatingrate credit enhancement adjustment for high-ratedclasses tends to level off since all loans are stressed todefault. A longer time horizon also creates additionaluncertainty and increases the possibility of interest rateincreases. Hence, loans with longer terms to maturity,inclusive of contractual extensions, require more creditenhancement. Last, but not the least, interest rate capsduring the loan term help offset floating rate risk, but donot completely eliminate it. Term caps do not generallyprovide any protection for interest advancing from ratevolatility during any potential tail period after the loanmaturity date, so loans that default at or near balloondates may still be exposed to interest rate risk.

While we believe that Moody’s approach to floating rateCMBS offers a solid conceptual framework, we do nothave the benefit of a rich set of empirical data to test ourresults. This is unfortunately the case for CMBS researchin general. When there are more floating rate loans beingoriginated and serviced in the future, the assumptionsunderlying this approach could be verified or modified.

John Junyu Chen and Milton Chacon are both VicePresident and Senior Analyst at Moody’s Investors Service. They can reached at chenj@moodys.com orchaconm@moodys.com.1The loan term in this report includes contractual extension periods. Thetail period is defined as the period of time following the maturity date ofthe loan during which the servicer is required to resolve any defaults andliquidate defaulted assets.

2Other financing alternatives such as short-term fixed-rate debt offered bysome insurance companies are generally not available in the CMBSmarket. Other alternatives could emerge as lenders respond to marketneeds

3Fixed-rate loan prepayment protection is typically a combination of lock-out, yield maintenance and defeasance with a short open period a few months prior to the maturity date.

4For example, the increase in the ten-year Treasury rate from 4.7% to 6.3%in 1999 generated greater interest in floating rate financing by traditionalconduit borrowers.

5For example, if the in-place leases are below Moody’s assessment ofsustainable market rents, then an upward adjustment to in-place cash flowmight be considered. A myriad of factors, such as the schedule of leaserollovers and availability of capital for re-tenanting costs, are considered inarriving at conservative upward adjustments to in-place cash flows. Alsotaken into consideration are any plans and capital expenditures toimprove the property. Capital spent for value creation (e.g., upgrading fromClass C to Class B), as opposed to value preservation (e.g. repairing roofand HVAC) may be considered favorably.

6For further information on Moody’s approach to subordinate debt, seeCMBS: “Moody’s Approach to A-B Notes and Other Forms ofSubordinate Debt”, February 4, 2000.

7Recently, we have seen an increasing interest from issuers to deviate froma pure sequential principal pay structure, with particular emphasis ondiverting a portion of the principal proceeds to the below investment gradeclasses. As the timing of repayment becomes more certain, holders of theseclasses of bonds are willing to pay more for them, everything else beingequal. From the issuer’s perspective, this results in the receipt of greaterproceeds and thus a more profitable execution.

8Based on the historical LIBOR distribution, 95% of the time LIBORwould not increase by more than 600 basis points during a three-yearperiod or more than 800 basis points during a five-year period. Thisspread differential between the five- and the three-year term demonstratesthe potential volatility due to term.

9For a discussion on various forms of interest rate models, see Chan,Karolyi, Longstaff and Sanders, “An Empirical Comparison of AlternativeModels of the Short-Term Interest Rate”, in The Journal of Finance,1992. For the particular purpose of floating rate CMBS rating method-ology, we applied a simple form of the mean-reverting stochastic processmodel (i.e. the Vasicek model specification). The computation follows Dixitand Pindyck, Investment Under Uncertainty, 1993, PrincetonUniversity Press. Some modifications were made in deriving Moody’sCMBS stressed interest rate assumptions.

10The servicer is never required to advance balloon amounts. However,upon a balloon default, the servicer will continue to advance an assumedmonthly debt service based on the pre-default loan terms. If the floater isan interest only loan, there is no principal component to the servicer’sadvances. The servicer’s obligations are generally backed by the trustee andfiscal agent (if one exists), one of which is typically rated at least Aa3.

11Even though real estate may be considered an inflation hedge in the longrun, the borrower might not be able to increase rents at will due to thecontractual nature of rental agreements and the timing of the rollovers.Furthermore, the correlation between rents and inflation, and hencenominal interest rates, can be disrupted by other supply and demandfactors affecting the real estate cycle.

12In computing the break-even interest rate, we consider that borrowers aretypically motivated to support a property after the cash flow becomes insuf-ficient to pay the debt service due to temporary interest rate spikes sincethere is an option value to hold on to the property. A borrower may usefunds from other sources, postpone management fees, or delay capitalimprovements. Furthermore, certain temporary income such as above-market rents, which are not accounted for in Moody’s net cash flow, mayprovide additional liquidity.

13The empirical research on the correlation between property value andinterest rate is limited. For a diversified conduit pool, the joint probabilityis assumed around 0.6 to 0.7 for high-rated classes. For single asset orlarge loan pools with less diversity, a higher joint stress probability is typi-cally assumed.

14Loans with higher leverage have lower breakeven mortgage interest rates,and therefore higher interest rate advancing costs and higher loss severityfor interest rate related defaults.

15Any actual loans may have different terms, spreads or property typesfrom those assumed in this example, and therefore may have differentcredit enhancement adjustments.

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

13summer 2000