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

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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

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Overview

• Rating Agency surveillance
• Post-closing surveillance of transactions
• Rating actions

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Role of Rating AgenciesWhat 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

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Role of Rating AgenciesWhat is a CMBS Rating

• Three national statistical rating agencies
  routinely rate CMBS deals - Moodys, Standard
  Poors and Fitch. Most CMBS deals have at least
  2 rating agencies
• Each tranche of bonds in deal will have its own
  rating

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Role of Rating AgenciesInvestment Grade Ratings
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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

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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
• Issuers goal is to have lowest subordination
  levels possible

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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

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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

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Rating Agency Methodology

• In evaluating deals, rating agencies do
  individual loan analysis and portfolio or pool
  analysis

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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

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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

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Rating Agency Methodology

• In reviewing pools, rating agencies typically
  conduct a full file review of large loans, and a
  random sample of other loans

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Rating Agency MethodologyIndividual Loan
Analysis

• In evaluating individual loan, rating agencies
  typically re-underwrite stabilized net cash flow
  for collateral property, using rating agencys
  criteria for determining sustainable net cash
  flow, which is capped to determine stabilized
  value of the property

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Rating Agency MethodologyIndividual 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

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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

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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

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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

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Rating Agency Methodology

• Pool size and loan size analyzed because small
  pools or pools with disproportionately large
  loans concentrate risk

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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

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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

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Rating Agency MethodologyFloating 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

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Rating Agency MethodologyFloating 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

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Rating Agency MethodologySingle 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

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Rating Agency MethodologySingle 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

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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

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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

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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

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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

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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

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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