One week after the Federal Reserve announced that the Term Asset-Backed Securities Loan Facility (TALF) program would include commercial mortgage-backed securities (CMBS) issued before Jan. 1, 2009, Standard & Poor's released a change to its ratings model that could downgrade 90% of the highest-quality CMBS issued in 2007.
“The downgrade is something that could impact the Fed's plans and certainly will impact the market as far as the TALF is concerned,” says Kevin Petrasic, former special counsel of the Office of Thrift Supervision and currently counsel in the banking and financial institutions group at law firm Paul Hastings Janofsky & Walker in D.C.
In order to qualify for the program, under which investors obtain Fed financing to buy debt, CMBS pools will be required to have AAA ratings from two of the four TALF CMBS-eligible rating agencies, which include DBRS, Fitch Ratings, Moody's Investors Service, Realpoint and Standard & Poor's.
“Our preliminary findings indicate that approximately 25%, 60%, and 90% of the most senior tranches [by count] within the 2005, 2006, and 2007 vintages, respectively, may be downgraded,” S&P stated. “We believe these transactions are characterized by increasingly more aggressive underwriting than prior vintages.”
Whether or not other rating agencies follow suit remains to be seen. On June 8, New York-based Fitch Ratings issued a statement saying “super-senior AAA-rated classes are expected to stay AAA for the foreseeable future.”
The clock is ticking
The TALF program, which was first authorized in November, will provide up to $100 billion in non-recourse loans to investors to buy eligible CMBS and other asset-backed securities. The first round of TALF loans in March was extended to securities backed by auto and student loans, credit card debt and small business administration loans, among other asset types.
The first round of loans to help buy newly issued CMBS was set for June 16, while the first round of loans for purchasing existing CMBS is slated for late July. “What you end up with is a program that, at least for now, has a useful life that ends at the end of this year,” says Petrasic.
As of early June, however, no new CMBS had been issued this year and the TALF funding is just around the corner. The process of originating mortgages for CMBS, aggregating them into pools and securitizing those pools as bonds has historically taken three to six months, explains Patrick Sargent, president-elect of the Commercial Mortgage Securities Association (CMSA) and a partner with law firm Andrews Kurth in Dallas.
Under the TALF program, investors will be permitted to take out loans at a minimum of $10 million with a 5% equity stake. The New York Fed will offer three- and five-year, non-recourse, fixed-rate mortgages. Interest rates will correspond with the three- and five-year LIBOR swap rate plus 100 basis points.
The TALF extension is designed to help stimulate lending, Sargent says. “It will help banks say, ‘I see an exit strategy because I know that people will use TALF to buy AAA-rated securities’.”
Whether investors bite on the new TALF offering will depend on the health of existing CMBS, which has shown rapid deterioration in recent months and is expected to worsen as the year unfolds.
In the first quarter of this year, Fitch Ratings downgraded $5.9 billion of CMBS and placed another $6.8 billion on negative rating watch. In addition, the national default rate on commercial mortgages is forecast to jump from 1.6% at the end of 2008 to 3.9% by the end of this year and 4.7% by year-end 2010, according to Real Estate Econometrics.
In short, there's no guarantee to investors that the AAA bond they buy today will be a AAA bond tomorrow. “If there isn't a material improvement in the performance of the legacy loans themselves, if we're starting to observe widespread distress in commercial mortgage markets, then even as a potential investor for a new issue that is financing new transactions, it gives you some degree of pause,” notes Sam Chandan, chief economist for New York-based Real Estate Econometrics.
The ratings for peak-year CMBS issuance — 2005-2007 — were also less than stellar. The largest securitized pool during that period totaled around $7 billion. Some pools were backed by hundreds of loans, though the rating agencies typically only rated the top 10 largest loans in each pool.
The $7 billion securitization is an extreme example. Most pools generally ranged between $1 billion and $2.5 billion, especially during the last three to four years of securitization, explains Sargent of CMSA. But in the near future, the market is unlikely to see such massive loans, given fundamentals, and the heightened awareness of the need for transparency.
Chandan says future securitizations will be smaller, $1 billion and even less. He believes the new securitizations won't come from the banks but rather the conduit lenders — life companies, pension funds and investment banks — who make mortgages for the express purpose of securitization, not to hold these loans on their balance sheets.
Ryan Krauch, prinicipal of Los Angeles-based lender Mesa West Capital, says that his firm has traditionally made loans for value-add properties. Recently, Mesa West shifted its strategy and now focuses more on stabilized, institutional-quality assets and providing bridge loans.
As to whether the extension of TALF to include CMBS will ultimately help lenders like Mesa West Capital, Krauch is skeptical. “With luck it will jump-start more interest in the segment, but the federal government really needs to further vet it,” Krauch says. “Ultimately bondholders need to regain confidence in the system, and TALF won't do that.”