Morningstar has published a proposed method for rating single-asset/single-borrower (SASB) transactions. The new approach is slated to replace the “U.S. CMBS Subordination Model” with respect to SASBs and other forms of CMBS securities with similar credit and diversity profiles, including large-loan transactions and rake certificates. Morningstar has issued a request for comments on the proposal. We plan to provide our thoughts, described below, before the April 20th deadline, and encourage you to do the same. But first, answers to what are sure to be your most burning questions:
Q. What will happen to the ratings of existing transactions/securities?
A. Probably nothing. The new model was not designed to rock the ratings boat – according to Morningstar, the proposed method produces “substantially similar model outputs” to existing methods.
Q. So, what is the point of the introducing a new method?
A. “Transparency”. Morningstar asserts that its proposed loan-to-value (LTV) tranching will provide more transparency into the rating process by giving a direct indication of each tranche’s ability to withstand a property market value decline.
More generally, Morningstar is joining the ranks of several other ratings agencies (including DBRS, Moody’s, and KBRA) that have developed SASB-specific methodologies to account for the unique qualities of deals in the this space that can’t be captured by models designed for conduit analysis. In particular, credit risk in SASB deals can be more concentrated than in conduit deals depending on parameters like sponsor, property count, property type, and geographic location. Additionally, SASBs often involve institutional borrowers with strong bargaining power, which may result in loan provisions that differ from those contained in small balance conduit loans, particularly with respect to lender protections such as “bad-boy” guaranties, property release provisions, qualified transferee provisions and cash sweep triggers.
Q. How does it work?
A. LTV tranching. The process is centered on LTV benchmarks, which represent the maximum portion of mortgage debt that would qualify for a given rating. “A” ratings are anchored to sustain the Great Recession (a 54.25% market value decline). Morningstar adjusts its benchmarks based on characteristics of the property (type, location, quality, diversity, cash flow stability, market strength, etc.) and the loan (LTV, interest rate, amortization and additional layers of debt) and a review of the transaction structure and key legal documents. The adjusted benchmarks are then used to divide the loan balance into rated tranches.
Q. Does Dechert have comments?
A. Of course we do. With respect to property releases, Morningstar looks for: (1) a release price of at least 115% of the allocated loan amount; and (2) no “cherry-picking” provisions that include a minimum DSCR (or debt yield) and maximum LTV test. Typically, we see either a DSCR or an LTV test. Requiring both doesn’t make sense in the context of portfolio deals and many large-loan pools – which enjoy an upward LTV adjustment for diversification –based on the sheer number of appraisals that would be required.
The model does not address any of the other lender protections discussed above except to say that Morningstar “expects customary and prudent document provisions” and that any deficiencies may affect ratings. Given that these provisions tend to be more heavily negotiated in the SASB space, Morningstar’s aspirations toward transparency might be better served if it would specifically identify – as it did with the release provisions – the terms that it considers credit neutral.
Q. How can I submit comments?
A. Send an email. Submit your comments to NRSROconsulations@morningstar.com before 5 p.m. on April 20th, and be sure to include your name, title, organization, address, phone number and email address. Of course, if you’d prefer to discuss these proposed changes (or any other hot topics at the intersection of finance and real estate) with a real, live human being, please feel free to reach out to Rick Jones or Justin Gdula.