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John Junyu Chen and Milton Chacon Chen Chacon CMBS: Moody’s Approach to Rating Floating Rate

John Junyu Chen and Milton Chacon

John Junyu Chen and Milton Chacon Chen Chacon

Chen

John Junyu Chen and Milton Chacon Chen Chacon

Chacon

CMBS: Moody’s Approach to Rating Floating Rate Transactions

Commercial mortgage-backed securities (CMBS) collateralized by floating rate loans (floaters) have become an important part of the CMBS market. Because they typically have low prepayment penalties and short lock-out periods, floaters have generally

appealed to borrowers with transitional assets or short-term holding horizons. However, based on their interest rate expectations, some conduit borrowers may opt for floaters

as a flexible financing alternative that will

provide them with the opportunity to refi- nance in a more favorable interest rate environment.

Moody’s approach to rating floating rate CMBS transactions shares the same method- ology as that used for fixed-rate CMBS, except for an additional step necessary to assess the

credit risk associated with floating interest rates. First, Moody’s reviews the collateral perfor- mance and determines stabilized cash flows.

A fixed-rate-based baseline credit enhance-

ment is derived using Moody’s debt service coverage ratio (DSCR), loan to value (LTV) ratio and asset quality grade. In the next step, interest rates are stressed to determine the credit enhancement adjustment necessary to compensate for floating rate risk. This adjust- ment incorporates the impacts of both potentially higher interest advancing costs and additional term defaults associated with the interest payment volatility. 1 The default frequency at balloon is the same for both fixed-rate and floating rate CMBS. This adjustment is further calibrated to reflect the joint probability of simultaneous interest rate and real estate stresses. As in the fixed-rate CMBS rating methodology, the final step consists of portfolio adjustments for elements such as diversity, structural characteristics and quality of underwriting.

MARKET DRIVERS

at

A

two-year to five-year term and provides for a one-year or two-year contractual extension. The prepayment penalties are less onerous than their fixed-rate counterpart and may include a short lock-out period followed by a stepping down percentage penalty, as opposed to the potentially very expensive prepayment costs associated with yield main- tenance and defeasance. Floaters are often interest only loans, so the initial coverage is typically higher than for equivalent amor- tizing fixed-rate loans.

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for equivalent amor- tizing fixed-rate loans. summer 2000 7 The CMBS market currently offers commer- cial

The CMBS market currently offers commer- cial real estate borrowers two primary financing alternatives: long-term fixed-rate and short-term floating rate loans. 2 Long-term fixed-rate loans typically have ten-year terms, 20-year to 30-year amortization schedules and strong call protection. 3 This level of prepayment protection provides investors more certainty in cash flows and has helped make the current CMBS interest only (IO) market viable.

Long-term fixed-rate financing typically suits the needs of long-term borrowers with stabi- lized assets. On the other hand, floating rate financing is more attractive to borrowers that require prepayment and refinancing flexi-

bility due to the transitional nature of the real estate asset or the borrower’s expected short holding period. In addition, traditional conduit borrowers with stabilized assets may also consider floating rate loans. These borrowers anticipate that interest rates will decline at some point over the next few years,

which time they will prepay their loans

and lock in more favorable fixed-rate financing. 4

CMBS floating rate loan typically has a

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.) The Impact of Floating Interest Rate

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

The Impact of Floating Interest Rate on Expected Loss

Moody’s analysis of the credit impact of floating rate loans is based on the expected loss concept, which incor- porates both default frequency and loss severity. The frequency of default during the loan term is generally determined by the borrower’s ability to make debt service payments based on the property’s cash flow. Either a decline in property cash flow or an increase in debt service can increase term default frequency. Balloon default frequency depends on the interest rate environ- ment and balloon balance at the time the loan matures. If the balloon balances are the same, both floating and fixed-rate loans bear the same refinancing risk.

The loss severity represents realized losses on a CMBS collateral pool, and servicer advancing of default interest is assumed. Therefore, the loss severity has three major components: property value losses, workout costs, and advancing costs. Property value losses result from declines in the property values below the outstanding loan amounts, due to either reduced cash flows or rising capitalization rates. Workout costs include special servicing fees, legal costs and other third party fees. Advancing costs result from the servicer’s obligation to advance unpaid debt service on defaulted loans. 10 Upon final disposition of the defaulted asset, the servicer is reimbursed all advanced debt service and interest thereon, before any principal distributions are made to the certificate holders. Higher interest advances hence result in higher realized losses to the trust.

default frequency because rising interest rates may cause additional defaults during the loan term due to the mismatch between stable property cash flows and rising debt service. 11 The probability of floating rate- induced additional term defaults depends on the stressed interest rate as well as the capacity of the property’s cash flow to absorb rising debt service. Such capacity is reflected in the loan’s break-even interest rate. 12

• Loss Severity: For loans that would have defaulted under the related fixed-rate stress scenario, the severity of loss associated with property value losses and workout costs for these defaults are assumed to be unaffected by the floating rate. However, interest advancing costs will be higher if interest rates rise during the related workout period when a floating rate loan defaults, as the advancing rate is based on the then current interest rate. In contrast, after a fixed-rate loan defaults, the servicer is required to advance interest payments at the stated fixed-rate to the CMBS certificate holders. The additional advancing costs, if any, are deducted from the final liquidation proceeds, resulting in a higher loss severity in the event of default. For loans that default during the term due to the floating rate feature, i.e. potentially higher interest payments, the loss severity is expected to be lower than defaults caused by changes in real estate values. The losses on additional term defaults caused by interest rate volatility come primarily from workout and advancing costs.

Chart 2: The Incremental Impact of Floating Interest Rates on CMBS

Default Frequency

x

Loss Severity

=

Credit Loss

Balloon Defaults

Term Defaults

No impact; floating and fixed-rate loans have the same refinance risk at balloon

Higher; floating rate loans have higher term default frequency due to interest rate volatility.

Higher; floating rate loans may incur additional interest advancing costs.

Severity depends on whether a default is real estate or interest rate related

Higher; potentially higher term default frequency and greater loss severity due to higher interest advancing costs

The incremental credit impact of interest rate volatility on floating rate loans as compared to fixed-rate loans, assuming no interest rate caps, can be broken into default frequency and loss severity components, as shown in Chart 2 and summarized as follows:

• Default Frequency: The floating interest rate has no impact on balloon default frequency since both fixed and floating rate loans will face the same refinance environment. However, it could affect the term

Joint Interest Rate and Real Estate Stress

Moody’s has further considered the likelihood of both real estate and interest rate stress occurring simultane- ously. For example, arguments can be made that a severe real estate recession would typically be associated with a severe general demand contraction, during which period interest rates would be unlikely to rise to a high stress level. However, it would not be unlikely that a higher interest rate environment could coincide with a property

However, it would not be unlikely that a higher interest rate environment could coincide with a

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CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.) market downturn. Moody’s believes that the

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

market downturn. Moody’s believes that the floating rate adjustment should not be a pure addition to the baseline credit enhancement, therefore a joint probability factor is applied to the floating rate adjustment to reflect the possibility of both real estate and interest rate stress not occurring during the same period. 13

CALCULATING THE FLOATING RATE CREDIT ENHANCEMENT ADJUSTMENT

Moody’s has developed a CMBS floating rate approach to quantify the credit enhancement adjustment neces- sary to compensate for the floating rate risk. The approach incorporates loan specific inputs such as term to maturity, terms of borrower extension options, DSCR and LTV ratios, spread over LIBOR and the strike rate of the interest rate cap if one exists. This loan specific infor- mation, together with the stressed interest rate assumptions discussed above, is used to calculate an adjustment for each rated class of securities.

To illustrate our approach, we have selected three sample floating rate loans representing different levels of leverage with Moody’s LTVs of 65%, 85% and 95%. Chart 3 presents the calculation of floating rate credit enhancement adjustments for these three loans. In this example, the calculation is focused on the Aa2 class, however the same methodology applies to other rated tranches by varying the levels of interest rate stress together with incremental default frequencies and addi- tional advancing costs.

The following is a step by step explanation of the proce- dure for calculating the floating rate credit enhancement adjustment for a loan with a Moody’s LTV of 85%, as shown in Chart 3. The same procedure applies to the other two loans as well. The loan is assumed to have a three-year term plus a one-year extension, a spread of 2% over LIBOR, and no interest rate cap. For this example, the stressed interest rate for the Aa2 rating level is 14.25%, the sum of the stressed LIBOR of 12.25% and the spread of 2%. The breakeven interest rate is calcu- lated by dividing the property’s net cash flow by the loan amount. There are four steps involved in the calculation of floating rate credit enhancement adjustment:

• Step 1: Evaluate baseline default frequency. Using Moody’s fixed-rate rating methodology, assume that 22 points of credit enhancement are deemed necessary for an Aa2 rating, prior to considering floating rate risk. This credit enhancement considers a 55% default frequency and a 40% loss severity.

• Step 2: Calculate additional loss severity. For the base- line default frequency (55%), additional loss severity occurring due to increased interest advancing costs needs to be determined. The additional advancing rate per year is calculated as the difference between Moody’s hurdle rate of 9.25% and the Aa2 stressed interest rate of 14.25%, or 5%. Allowing for an average workout period of 1.5 years, the total additional advancing costs would represent an incremental loss in the event of default of 7.5% (1.5 years x 5%). The

Chart 3: Example of Calculating an Aa2 Floating Rate Credit Enhancement Adjustment

 

Loan (1)

Loan (2)

Loan (3)

Moody’s LTV Breakeven mortgage rate Stressed interest rate for an Aa2 rating

65%

85%

95%

15.38%

11.76%

10.53%

14.25%

14.25%

14.25%

Step 1:

Base case analysis (based on fixed-rate) Aa2 default frequency

Additional Loss Severity due to floating rate Annual additional interest advancing costs Total additional interest advancing costs (1.5 years) Credit loss due to additional advancing costs

 

Step 2:

35%

55%

90%

5.0%

5.0%

5.0%

7.5%

7.5%

7.5%

2.6%

4.1%

6.8%

Step 3:

Additional Term Defaults due to floating rate Additional term default frequency Loss severity of interest related defaults Credit loss due to additional term defaults

 

12%

22%

10%

16%

20%

24%

1.9%

4.4%

2.4%

Step 4:

Credit Enhancement Adjustment Aggregate Additional Credit Loss Joint Stress Probability

 

4.5%

8.5%

9.2%

65%

65%

65%

Floating Rate Credit Enhancement Adjustment

2.9%

5.5%

6.0%

8.5% 9.2% 65% 65% 65% Floating Rate Credit Enhancement Adjustment 2.9% 5.5% 6.0% 10 CMBSWORLD

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CMBSWORLD

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.) product of 7.5% (additional advancing costs)

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

product of 7.5% (additional advancing costs) and the 55% (baseline default frequency for Aa2) results in approximately 4.1 points of additional credit loss at the Aa2 rating.

• The floating rate credit enhancement adjustment is higher for loans with longer terms to maturity, inclu- sive of contractual extensions. All contractual extensions are assumed to be exercised in our analysis. Higher interest rate assumptions are used for longer- term loans to reflect the increased uncertainty about interest rate levels over a longer horizon.

• Floating rate loans are often interest only. Additional credit enhancement may be necessary due to the lack of loan amortization, in addition to the floating rate credit enhancement adjustments.

• Step 3: Estimate additional term defaults.As a result of interest rate stress for an Aa2 rating, an additional term default frequency of 22% is estimated based on the likelihood of the breakeven mortgage rate being lower than the stressed interest rate, bringing the total default frequency to 77% (55% + 22%). This estimate considers the option value for borrowers not to default immediately when the stressed interest rate exceeds the breakeven rate, as well as the probability distribu- tion of future property cash flows. The loss severity for the additional term defaults is primarily due to workout and interest advancing costs, estimated at 20%. Therefore, the additional credit loss from addi- tional term defaults is 4.4 points (22% x 20%). 14

• Step 4: Determine floating rate credit enhancement adjustment. Based on step 2 and step 3, the aggregate credit loss is 8.5%. (4.1% + 4.4%). However, the chance of an extreme interest rate environment and a severe real estate recession occurring simultaneously is not very high. Therefore at an Aa2 rating level, a 65% joint stress probability is applied to the floating rate- related credit loss of 8.5%, resulting in the final floating rate credit enhancement adjustment of 5.5 points (65% x 8.5%).

Chart 3 also presents the calculation for the other two loans with low and high leverage. The floating rate adjustment is lower for the low leverage loan (2.9%) and higher for the high leverage loan (6.0%). Note that the additional term default frequency for the high leverage loan is capped at 10% because the baseline stressed default frequency is already 90%.

 

INTEREST RATE CAPS

The above example illustrates the floating rate credit enhancement adjustment with no interest rate caps. Often, borrowers are required by lenders to purchase interest rate caps to mitigate rate volatility during the loan term. An interest rate cap has two primary credit benefits: (1) reducing the additional default frequency during the term, and (2) reducing the interest payment shortfall, until the cap expires, for loans that do default during the term. Moody’s prefers that the cap issuer be rated at least Aa2 to receive the full benefit for the interest rate cap.

Timing of Defaults

To determine the benefit of a cap, it is necessary to consider the timing of defaults. Lower leverage loans will generally take longer to default since the likelihood of short-term credit deterioration is lower, and shorter term loans will tend to have more defaults closer to the balloon date. Chart 4 presents an illustration for a loan with a 3-year term. Assume that an all-in interest rate cap with a strike rate of 9.25% is purchased for the loan

In general, the floating rate credit enhancement adjust- ments have the following characteristics:

• The floating rate credit enhancement adjustment increases with leverage, everything else being equal. For example, an investment grade loan may have a floating rate adjustment that is only half of the adjustment required for a loan with conduit-type leverage. This difference in the penalty reflects the capacity of the investment grade loan to absorb higher interest rate increases during the term without causing a loan default.

• The floating rate penalty levels off at a Moody’s leverage of 95% to 100%. At the high rating levels, most of the highly leveraged loans in the pool are already assumed to default even under our fixed-rate stress scenarios, therefore the floating rate penalty consists mostly of the increased advancing costs resulting from stressed interest rate scenarios.

term, and that on average it will take 18 months to work out a defaulted loan. Should interest rates rise shortly after the loan is originated, and the all-in rate for the

sample loan becomes higher than 9.25% for the next five years, there are three possible scenarios for the timing of default and the related advancing costs.

• Scenario 1: The loan defaults at the end of the first year and is being worked out while the cap is still in effect. The loan experiences no advancing costs in excess of the 9.25% hurdle rate, because the interest rate cap effectively removed all incremental advancing costs due to interest rate increase. As a result, like a fixed-rate loan, there is no incremental loss exposure for this loan.

• Scenario 2: The loan defaults at the end of the second year of the term. The cap prevents incremental advancing costs during the third year of the loan term when the loan is being worked out. However, during the last six months of the workout period the servicer

 

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CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)   defaults. Furthermore, during the workout

CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

 
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)  

defaults. Furthermore, during the workout period floating rate bonds may incur higher losses due to poten- tially higher interest advancing costs. In general, higher leveraged loans, as indicated by Moody’s LTV ratios, require more credit enhancement as there is less oppor- tunity for the equity position to help absorb the interest payment risk.As leverage becomes very high, the floating rate credit enhancement adjustment for high-rated classes tends to level off since all loans are stressed to default. A longer time horizon also creates additional uncertainty and increases the possibility of interest rate increases. Hence, loans with longer terms to maturity, inclusive of contractual extensions, require more credit enhancement. Last, but not the least, interest rate caps during the loan term help offset floating rate risk, but do not completely eliminate it. Term caps do not generally provide any protection for interest advancing from rate volatility during any potential tail period after the loan maturity date, so loans that default at or near balloon dates may still be exposed to interest rate risk.

While we believe that Moody’s approach to floating rate CMBS offers a solid conceptual framework, we do not have the benefit of a rich set of empirical data to test our results. This is unfortunately the case for CMBS research in general. When there are more floating rate loans being originated and serviced in the future, the assumptions underlying this approach could be verified or modified.

 

6 For further information on Moody’s approach to subordinate debt, see CMBS: “Moody’s Approach to A-B Notes and Other Forms of Subordinate Debt”, February 4, 2000.

7 Recently, we have seen an increasing interest from issuers to deviate from

 

a

pure sequential principal pay structure, with particular emphasis on

diverting a portion of the principal proceeds to the below investment grade classes. As the timing of repayment becomes more certain, holders of these classes of bonds are willing to pay more for them, everything else being equal. From the issuer’s perspective, this results in the receipt of greater proceeds and thus a more profitable execution.

 

8 Based on the historical LIBOR distribution, 95% of the time LIBOR would not increase by more than 600 basis points during a three-year period or more than 800 basis points during a five-year period. This spread differential between the five- and the three-year term demonstrates the potential volatility due to term.

9 For a discussion on various forms of interest rate models, see Chan, Karolyi, Longstaff and Sanders, “An Empirical Comparison of Alternative Models of the Short-Term Interest Rate”, in The Journal of Finance, 1992. For the particular purpose of floating rate CMBS rating method- ology, we applied a simple form of the mean-reverting stochastic process model (i.e. the Vasicek model specification). The computation follows Dixit and Pindyck, Investment Under Uncertainty, 1993, Princeton University Press. Some modifications were made in deriving Moody’s CMBS stressed interest rate assumptions.

10 The servicer is never required to advance balloon amounts. However, upon a balloon default, the servicer will continue to advance an assumed monthly debt service based on the pre-default loan terms. If the floater is an interest only loan, there is no principal component to the servicer’s advances. The servicer’s obligations are generally backed by the trustee and fiscal agent (if one exists), one of which is typically rated at least Aa3.

11 Even though real estate may be considered an inflation hedge in the long

run, the borrower might not be able to increase rents at will due to the contractual nature of rental agreements and the timing of the rollovers. Furthermore, the correlation between rents and inflation, and hence nominal interest rates, can be disrupted by other supply and demand factors affecting the real estate cycle.

12 In computing the break-even interest rate, we consider that borrowers are typically motivated to support a property after the cash flow becomes insuf- ficient to pay the debt service due to temporary interest rate spikes since there is an option value to hold on to the property. A borrower may use funds from other sources, postpone management fees, or delay capital improvements. Furthermore, certain temporary income such as above- market rents, which are not accounted for in Moody’s net cash flow, may provide additional liquidity.

13 The empirical research on the correlation between property value and

John Junyu Chen and Milton Chacon are both Vice

President

and

Senior Analyst

at

Moody’s

Investors

Service. They can reached at chenj@moodys.com or chaconm@moodys.com.

1 The loan term in this report includes contractual extension periods. The tail period is defined as the period of time following the maturity date of the loan during which the servicer is required to resolve any defaults and liquidate defaulted assets.

2 Other financing alternatives such as short-term fixed-rate debt offered by some insurance companies are generally not available in the CMBS market. Other alternatives could emerge as lenders respond to market needs

 
 

interest rate is limited. For a diversified conduit pool, the joint probability

3 Fixed-rate loan prepayment protection is typically a combination of lock-out, yield maintenance and defeasance with a short open period a few months prior to the maturity date.

is

assumed around 0.6 to 0.7 for high-rated classes. For single asset or

large loan pools with less diversity, a higher joint stress probability is typi- cally assumed.

 

4 For example, the increase in the ten-year Treasury rate from 4.7% to 6.3% in 1999 generated greater interest in floating rate financing by traditional conduit borrowers.

 

14 Loans with higher leverage have lower breakeven mortgage interest rates, and therefore higher interest rate advancing costs and higher loss severity for interest rate related defaults.

5 For example, if the in-place leases are below Moody’s assessment of sustainable market rents, then an upward adjustment to in-place cash flow might be considered. A myriad of factors, such as the schedule of lease rollovers and availability of capital for re-tenanting costs, are considered in arriving at conservative upward adjustments to in-place cash flows. Also taken into consideration are any plans and capital expenditures to improve the property. Capital spent for value creation (e.g., upgrading from Class C to Class B), as opposed to value preservation (e.g. repairing roof and HVAC) may be considered favorably.

15 Any actual loans may have different terms, spreads or property types from those assumed in this example, and therefore may have different credit enhancement adjustments.

 

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