Upgrades Outpace Downgrades for CMBS

Two credit rating agencies are both seeing upgrades on commercial mortgage-backed securities loans exceed downgrades so far this year, pointing to continuing strength in the economy.

Moody's Investors Service reports that CMBS turned in a "steady performance" during the first half of 2004, with 231 confirmations, 113 upgrades and 112 downgrades on 456 tranches.

The rating agency's Moody's Surveil-lance Trends scores show that "the vast majority of fixed-rate investment grade CMBS tranches [77%] should remain relatively stable for the near term, while investment grade upgrades should continue to exceed investment grade downgrades."

In the second quarter of 2004, Moody's-rated floating rate transactions saw the largest portion of downgrades at 29 tranches from seven deals, the rating agency reports.

Tad Philipp, Moody's managing director for CMBS, said, "Floating-rate bond performance was weakened by poorly performing properties." Moody's reviewed 10 conduit transactions totaling 97 classes during the second quarter and 26 of these were upgraded.

Mr. Philipp said, "Three conduit transactions experienced both upgrades of the senior classes and downgrades of the junior classes, with the downgrades stemming from an increased share of specially serviced or high loan-to-value loans."

Moody's also reports rising CMBS "loan leverage and declining structural protections," with as many as 28% of loans showing 100% loan-to-value ratios based on Moody's valuations.

And Standard & Poor's reports that rating activity among S&P-rated CMBS for the recent quarter resulted in the second-highest number of upgrades ever in a three-month period and the lowest number of downgrades since the third quarter of 2001.

Overall, there were 155 CMBS ratings actions during the second quarter, which brings the total year-to-date number to 268. It also places the year in a position to exceed last year's record number of upgrades and is likely to exceed last year's total number of rating changes. As well, the ratings agency expects 2004 to yield fewer downgrades than the 215 that were initiated last year.

Roy Chun, a managing director in S&P's structured finance surveillance group, noted, "This is reflected in the 30 negative CreditWatch actions taken in the quarter. A majority of these actions occurred in floating-rate transactions where adverse loan selection has become highly apparent. Good performing loans with high debt service coverage are finding a lot of available refinancing options, leaving the pool with the more troubled and less attractive properties."

The S&P report also finds that ratings from three transactions were either placed on "CreditWatch with negative implications or were lowered."

These actions were "heavily influenced" by the deterioration in the "operating performance" of a couple of large hotel assets.

Although the rating agency avoided hotel loans overall in 2002 transactions, some of these loans did get into CMBS transactions.

A third rating agency, Fitch Ratings, expects "the slow climb of U.S. commercial mortgage-backed securities to continue as the cumulative default rate reaches 5% by the end of this year."

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