“With increased origination volume…it is inevitable that there will be some slippage in credit standards, which has been observed across 2013 vintage deals,” Kroll Bond Ratings said in a recent commercial mortgage-backed securities research report. “More recently, some marketplace constituents have expressed concerns that a rising rate environment will contribute to credit degradation, particularly if lenders and borrowers are unwilling to accept loans with lower leverage points to offset the impact on rising debt service caused by higher coupon loans.”
The report by senior directors Terri Magnani and Nitin Bhasin examined six conduit deals Kroll rated this year with loans that were rate-locked primarily in the second quarter before the impact of the rate increase took effect. It finds, “The impact of the rate raise varied somewhat across the sampled transactions, depending on their individual characteristics, including the level of unadjusted coupons and the degree to which partial term and full term [interest-only] loans were present in the pool.”
The analysts conclude, “The credit enhancement levels associated with each transaction would have been higher by varying degrees if rated under…higher coupon scenarios” in which the coupon rates of the collateral loans are increased by 75 and 150 basis points.
“This had a material impact on each deal’s weighted average Kroll debt service coverage as well as the average deleveraging that occurred in each pool due to amortization, which decreased by approximately 10% and 19%, respectively, in each scenario,” the Kroll researchers said in the report.
They attributed the credit enhancement changes “primarily…to changes in [Kroll debt service coverage] and Kroll loan-to-value.”
As a result of rising rates and the focus on them, Kroll noted in the report that “the competitiveness of balance sheet lenders and life insurance companies” has increased.
“Unlike conduit programs, these lenders originate loans benchmarked to the 10-year U.S. Treasury yield, providing an approximately 16 basis point advantage over CMBS,” the researchers noted. “Although this could prompt a decline in conduit originations, we believe that any decrease in production will be short-lived given the high volume of maturing loans in the coming years, absent an unanticipated market dislocation.
“The more likely scenario is that credit quality may be negatively affected by increased competition and a gradual rise in interest rates as the Fed reduces quantitative easing.”
Issuance, which has been up 30% or more year-over-year since 2008-2009, is likely to continue increasing, according to Kroll.
“It is our expectation that we will continue to see rising issuance volumes in the coming years,” the Kroll analysts said in the report.
The researchers conclude, “The ultimate impact of higher rates on credit quality in the CMBS sector (and in turn credit enhancement levels) remains to be seen, as lenders will ultimately adapt to increasing interest rates by changing their origination parameters in a number of respects.
“This could entail reducing in-trust leverage, increasing IO period, changing loans terms and potentially offering additional debt outside the trust.”