A number of investment banks have been increasing the portion of high-quality loans backing commercial mortgage bonds. These loans, while not publicly rated, have many of the characteristics of investment grade loans, such as good structure and experienced sponsorship, and they are secured by good quality properties in primary markets. They are the type of loans that, if sizeable, might end up being securitized on their own. When added to the mix of collateral in CMBS conduits, they boost the overall credit metrics of a deal.
Last year, investment grade loans accounted for just 3% of conduits rated by Kroll Bond Ratings, on average. But so far this year, the average level has risen to 4.1%. And since April, there have been several deals with exposures to investment grade loans in the mid-to-high teens.
At the same time, banks are also increasing the proportion of loans with very high leverage, or loans that represent more than 110% of the value of the property securing them. According to Kroll, these highly leverage loans now represent more than one-third of total exposure in conduits completed this year.
Furthermore, the presence of "ultra" high leverage loans, those with loan-to-value ratios in excess of 120%, has tripled year to date, and currently stands at 6.1%.
The net result of this "credit barbelling" is that the overall leverage in a pool of loans may not represent the true risks to investors. "You can end up with a transaction that has a weighted average LTV that really isn't much different than all the other deals out in the marketplace, but you could have a pool where a sizeable number of investment grade loans with low leverage are skewing the average downward, and offsetting a meaningful exposure to higher leverage loans," said Eric Thompson, Kroll's head of CMBS.
Fitch Ratings is also concerned about the trend. "Anytime you have barbelling occurring, the average is less meaningful and opens up potentially more volatility for loans at the lower end of the metric being measured," said Huxley Somerville, managing director and head of Fitch's U.S. CMBS group.
"You are getting a bigger dispersion around the average; it is a very different pool to one that would have more homogenous loans."
Interestingly, the same high quality, $1.8 billion commercial mortgage loan secured by 11 Madison Avenue in New York has shown up in the collateral pool of two CMBS conduits as well as on its own, in a large-loan CMBS.
The loan, which helped fund SL Green Realty Corp.'s purchase of the property for $2.3 billion in August from the Sapir Group, has credit opinion of A- from Fitch and AAA from Kroll.
Lower LTVs, But Bigger Dispersion Around Average
The property benefits from strong, stable tenants. Credit Suisse and Sony are the two largest, occupying a total of 80.7% of the building’s square footage. Together they represent 78.9% of total base rent. And there is little tenant "rollover" risk, since both Credit Suisse and Sony have leases that end six or more years after the mortgage matures. Of the remaining tenants, seven have lease expirations through 2025, the year in which the loan matures, accounting for 17.4% of total base rent.
Not only is the loan high quality, it also has a lot of moving parts.
The bulk of it — nine senior A notes with an aggregate balance of $397.5 million as well as the three subordinated B notes — were contributed MAD 2015-11MD, a single-asset CMBS launched on Sept. 8 by Deutsche Bank, Morgan Stanley and Wells Fargo.
Another portion of the loan, a $35 million senior A note, was contributed to Wells Fargo’s, $814 million, WFCM 2015-NX33 transaction launched on Sept. 21; and another $70 million senior A note was contributed to Deutsche Bank and Cantor Fitzgerald's $1.1 billion conduit COMM 2015-CCRE26, which launched Sept. 15.
It doesn't stop there; 11 Madison Avenue is expected to show up as collateral for future CMBS conduits, supporting an additional five senior A notes with an aggregate balance of $261.8 million, according to rating agency reports.
The CMBS that high-quality loans are being added to have a lot of sins to hide. Over the past two years, competition to underwrite commercial mortgages has led to a marked deterioration in credit quality. This has resulted in an increase in the number of loans in CMBS conduits with high levels of leveraged; loans on properties encumbered by additional debt not included in trusts; and loans that pay only interest and no principal for either part or all of their terms.
This deterioration, in turn, has prompted rating agencies to require increased levels of credit support across the capital stack. Even the senior triple-A notes issued by CMBS, which typically benefit from subordination of 30%, meaning that a transaction has to suffer a loss of 30% of its principal before those bonds get hit, are seen at greater risk.
"For the last year, originators have had to think about the subordination of triple-A ratings at the super senior level," said Somerville. "Right now the enhancement is at 30% but further increases in higher leveraged loans and riskier credit loans could move subordination above 30% — and if underwriting continues to decline, credit enhancement will continue to rise and that is going to happen."
Offset to a Potential Rise in Credit Enhancement
Adding investment grade loans the mix of collateral may help sponsors avoid increasing subordination. To the extent that collateral is treated as triple-A, it doesn’t add to the subordination required for a senior rating, and therefore "provides the pool with lower credit enhancement levels than if they were not in the pool," said Somerville.
"At triple-B-, the credit enhancement is going to be 5% lower than it would be if the investment grade loan hasn't been in the pool at all. If you had 8% credit enhancement at triple-B minus and 5% of that was an investment grade loan you would go from 8% to 7.625%," he said.
Investment grade loans are serving to relieve subordination requirement but they also mask a creeping risk in conduits — the rise of ultra-high leveraged loans. Investors, particularly those buying subordinate paper, need to be aware that rating models may not penalize the highly leveraged loans as much as they gives benefit to the rise in investment grade loans.
"While investors at the top of the credit stack will reap the benefits from a higher proportion of investment grade loans, investors at the triple-B level won't; especially in a situation where barbelling is occurring," said Thompson. These investors, he said "are more likely to bear the brunt of any defaults associated with the 110% LTV loans."
Among deals rated by Kroll year to date, the average LTV for pools that included investment grade loans dropped by more than 3 percentage points, to 102.8%, from 106% without the high-quality loans. In some cases, masking effect was even more marked; as much as 10 percentage points.
In some cases, Kroll has required less subordination for BBB- rated securities associated with pools that didn’t include investment grade loans, and had a relatively higher pool KLTV; compared to subordination required for deals that, because of the investment grade loans, may have had lower overall pool leverage.
"The reason is that certain deals, although they have a higher proportion of investment grade loans, also have large numbers of loans with KLTVs in excess of 110% and maybe they don’t have much amortization," Thompson said.
"Whereby a pool with the same WA pool LTV might not have investment grade loans but may have had a more normal risk distribution in terms of leverage, which reduces the likelihood of any individual loan causing an outsized loss to the trust."
Such is the case for MSBAM 2015 C25, where the bulk of the collateral pool, 44 or 80.6%, are loans with KLTVs in excess of 100%, and 20 of those loans have KLTVs in excess of 110%.
Kroll said in its presale report that the proportion of highly leverage loans is among the highest of the conduits it rated in the last six months. Nevertheless, the absence of investment grade means MSBAM C25 benefits from "more uniform risk distribution relative to deals that have slightly less overall leverage, but only because their collateral includes some investment grade loans."