S&P’s ruminations on reforming the way it rates commercial mortgage-backed securities, or CMBS, has become a hot topic since the agency made its request for comment on the changes back in May.
Not only do the potential changes have implications for banks, which may find $235bn worth of AAA-rated CMBS suddenly downgraded, it also has implications for CDOs, and the Federal Reserve’s Talf programme, which requires eligible CMBS to have only triple-A ratings.
In any case, S&P on Friday released its updated proposed methodology on Friday. The various documents make for very interesting reading, in particular the agency’s new criteria for credit enhancement or credit support, which cushions against potential losses. The agency wants CMBS credit enhancement levels sufficient for AAA-rated tranches to be able to withstand some pretty severe declines (40 to 50 per cent) in the value of commercial property.
Here’s S&P on its proposed credit enhancement level:The centerpiece of these updated criteria is the specification of an “archetypical pool” and its associated credit enhancement level at the ‘AAA’ rating category. Under our revised criteria, our analysis led us to arrive at a ‘AAA’ credit enhancement figure of 19% for the archetype pool. This represents a major recalibration of our CMBS criteria and is intended to enhance the comparability of U.S. CMBS ratings with ratings in other sectors, such as U.S. corporates, U.S. municipals, sovereigns, and other areas of structured finance. Many respondents to the request for comment stated that we appeared to be “backing into” a ‘AAA’ credit enhancement level of 20%, and commented that the selection of this figure seemed “arbitrary.” In fact, we based our decision to set credit enhancement levels to approximately that level on numerous factors [including the potential property declines mentioned above]. . .
One of those factors was the historical trend in the level CMBS credit enhancement. It looks like this:
So S&P’s new 19 per cent target is trending towards the level predominant in 2002 and 2003. Unsurprisingly perhaps, you can also see that between 2002 and 2007, credit enhancement levels declined rather consistently, falling to 12.1 per cent by 2007.
That decline did not go unnoticed by markets, which reacted accordingly, according to S&P:
Interestingly, the market reacted to declining credit enhancement levels by credit tranching the ‘AAA’ portion of transactions into senior tranches with 20% credit enhancement and junior tranches with lower levels of credit enhancement. The first transaction to employ that structure was CSFB 04 C4, which priced on Oct. 27, 2004 (7). It was only a few months later, in early May 2005, that the market went a step further by starting to divide the tranches with 20% enhancement into “super duper” tranches with 30% credit enhancement and mezzanine tranches at the ‘AAA’ level with 20% credit enhancement. The first transaction to display such a structure was WBCMT 05 C18 (8), which had three layers with ‘AAA’ ratings: (i) six “super-duper senior” tranches with 30% credit enhancement; (ii) one “super senior” tranche with 20%; and (iii) one “senior” tranche with roughly 13.7%. Today, the “super seniors” are generally called “AM” classes (”M” for mezzanine) and the “seniors” are called “AJ” classes (”J” for junior). The top tranches are still called “super dupers”.
Et voila, fast forward to June 2009 — when markets are reacting to the new proposed S&P methodology and potential downgrades. From the FT:
Braced for such downgrades, investment banks have been repackaging existing bonds in the past week to add credit enhancement.
This trend could accelerate, analysts said.
Related links:
CMBSnafu - FT Alphaville
Re-mimicking the crisis - FT Alphaville
Worries over systemic risk in CMBS - FT
Threat to triple-A rating of $235bn in CMBS - FT
Repackaging by banks helps CMBS - WSJ
