Echoes of the Great Recession in Commercial Real Estate

The Destiny USA mall reopens as coronavirus restrictions are eased in Syracuse, N.Y., July 10, 2020. (Maranie Staab/Reuters)
Ratings for some commercial-mortgage assets suggest a repeat of 2008.

After facing widespread condemnation for their contributions to the 2008 financial crisis, U.S. credit-rating agencies have largely avoided scrutiny during the coronavirus recession. Indeed, the Federal Reserve used credit ratings to determine whether certain classes of borrowers should get emergency loans and what interest rates to charge them. This move contravened the spirit of Dodd-Frank, which sought to separate credit ratings from federal regulation, while underscoring the fact that the 2010 reform failed to replace the assessments of highly conflicted private firms in financial-industry oversight.

Unfortunately, these conflicts of interest remain in place and in some cases have been exacerbated by the entrance of smaller competitors into the ranks of SEC-licensed Nationally Recognized Statistical Rating Organizations (NRSRO). These problems have flown under the radar in 2020 because the recession was caused by the pandemic rather than by financial engineering gone awry. Also, aggressive fiscal and monetary policies have limited the number of large, institutional defaults we have seen thus far. If highly rated yet insolvent firms continue to service their debts with the help of the government, regulators can overlook the accuracy of their ratings. . . . Indeed, high ratings may even be seen as reflecting the possibility that government will come to the rescue of a distressed borrower.

One category of bonds that has yet to receive federal support is Single Asset/Single Borrower Commercial Mortgage Backed Securities (SASB CMBS). Like the Residential Mortgage Backed Securities instrumental in the financial crisis, CMBS are serviced from principal and interest payments on a pool of real-estate loans. But the underlying mortgages are liens on large, income-producing properties such as office buildings, apartment complexes, hotels, and shopping malls.

While many CMBS deals are backed by dozens of mortgages, others are supported by just a handful of properties. In some cases, the mortgage pool consists of a few properties owned by a single borrower or even just a single property.

The problem with single-asset and single-borrower deals is the lack of diversification. Mortgage pools containing a mix of properties in various categories scattered around the country are less likely to encounter circumstances in which cash flows shrink catastrophically. While a mortgage on a shopping mall in New York may stop performing, its impact on the overall flow of interest and principal payments will be diluted by the Houston office building and the Florida apartment complex that keep paying and retain their appraised value.

But if the mortgage pool contains only that New York State shopping-mall loan, its ability to perform becomes highly dependent on the public-health policies of Governor Andrew Cuomo or adverse events such as an anchor tenant filing for bankruptcy.

Perhaps for this reason, the Federal Reserve excluded Single Asset and Single Borrower CMBS deals from eligibility when it restarted its Term Asset Backed Securities Loan Facility (TALF) in March. Under TALF, the Federal Reserve lends money to help investors purchase asset-backed bonds on the secondary market, thereby supporting the prices of these assets. Although the program includes AAA-rated bonds backed by auto loans, credit-card receivables, leveraged bank loans and commercial mortgages, the Fed term sheet explicitly excludes SASB CMBS.

But while the Fed recognized the heightened risk of SASB CMBS deals, rating agencies awarded AAA ratings to hundreds of senior CMBS securities with poorly diversified collateral pools prior to the coronavirus recession.

Many of these deals — especially those backed exclusively by shopping malls — have performed poorly during 2020, suffering interruptions in debt service and/or sharp reductions in appraised value. In some cases, the deterioration in mall performance had begun well before COVID-19 struck, as e-commerce and local economic challenges reduced foot traffic.

In some cases, rating agencies recognized that their AAA ratings were no longer tenable and downgraded the senior bonds.  Seven formerly AAA-rated CMBS securities backed by one to five mortgages have been downgraded by two or more “notches” (granular rating levels) since March. These so-called “fallen angels” include retail locations from New York to California.

Multi-Notch Downgrades of Senior CMBS Securities Backed by Shopping Mall Mortgages

In the two most extreme cases — one backed by a Buffalo, N.Y., shopping mall and another backed by four properties in different states — formerly AAA securities were slashed to speculative-grade levels, reflecting the NRSRO’s recognition that the bonds carry high levels of risk. The market concurs. According to data from Solve Advisors, potential buyers for these two bonds are offering less than seventy cents on the dollar — an extraordinary outcome for risk-intolerant bondholders who acquired these assets with the assurance that they were safe by SEC-certified NRSROs.

Moody’s–rated deals do not appear in the table because I have not found recent single-asset or large-loan CMBS downgrades by that firm. But that does not mean that Moody’s completely avoided assigning questionable AAA (or in Moody’s case Aaa) ratings to SASB CMBS securities.

One set of Moody’s CMBS ratings that is not aging well is its assessment of NCMS 2019-NEMA, a deal backed by a single luxury rental apartment building in San Francisco. The property, called San Francisco NEMA, has 754 residential units and 11,184 square feet of street-level retail capacity. Located across the street from Twitter’s world headquarters, NEMA was part of an ambitious plan to revitalize San Francisco’s seedy Mid-Market neighborhood.

Unfortunately, Twitter is now a leader in the transition to remote work, decreeing in May that most employees will have the choice to work from home even after the pandemic ends. A combination of remote work, lockdowns, and civil unrest has triggered a mass exodus from NEMA’s San Francisco neighborhood. Area rents have fallen about 30 percent from pre-pandemic levels while vacancies have soared. Recent (non-public) investor reports on NCMS 2019-NEMA indicate that the building’s occupancy rate has fallen to 70 percent, compared with 94 percent at deal inception.

Yet despite the sharp drop in revenue available to San Francisco NEMA, Moody’s had not downgraded any of its ratings on NCMS 2019-NEMA. DBRS Morningstar, the other agency covering the deal, has left most of its ratings unchanged as well. It maintains AAA ratings not only on the most senior Class A certificates but also on Class B bonds, which are subordinated to Class A.

In contrast to the inflated subprime RMBS ratings of 2007, today’s dubious SASB CMBS do not pose a systemic threat. The asset class is relatively small, as is the volume of derivative securities that reference these bonds. But ratings failures in the SASB CMBS sector provide evidence that Dodd-Frank–era reforms did not fix the credit-ratings industry, leaving in place a regime that could trigger a future financial meltdown.


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