Commercial Mortgage Backed Securities Downgraded by S&P

Commercial property crunchtime continues to unravel as Downgrades Hit Commercial Mtge-Backed Securities Market:

Bonds backed by commercial mortgages were hit Tuesday after Standard & Poor’s downgraded several CMBS issues amid continued signs of strains in the market for loans to build office malls and shopping centers.

The CMBX Series 5, the most recent derivatives index based on bonds backed by commercial mortgages, fell three points to 72 cents on the dollar on the downgrades, according to Derrick Wulf, a senior portfolio manager at Dwight Asset Management in Burlington, Vt.

S&P cut several of these securities because of a recent change in its rating methodology.

“They have put a lot of bonds on watch for downgrade after updating their methodology, and this is making the market nervous,” Wulf said.

The commercial real estate market is grappling with a worsening outlook. Delinquencies have risen to about 3%, with hotels seeing the greatest month-to- month increase at 3.26%, up from 2.02%, according to a note from Moody’s Investors Service. The aggregate delinquency rate is likely to go up further, to between 5% and 6% by the end of the year, according to Moody’s estimates.

Banks holding commercial mortgages on their balance sheets are expected to feel the pinch as borrowers default on their loans. On Tuesday, Goldman Sachs ( GS) reported stellar second-quarter results but took a $700 million hit on its holdings of commercial real estate mortgage loans. At the end of the quarter, Goldman had $6.4 billion of commercial real estate loans that were “marked really in the low 50s,” meaning reduced by almost half their original valuation, said David Viniar, Goldman’s CFO, Tuesday on the bank’s conference call.

More downgrades are expected, which means more volatility ahead for the CMBS market, as S&P is expected to “roll out the results of their new methodology over the next three to six months,” said Darrell Wheeler, head of securitization research at Citigroup, in a note to clients.

The downgrades mean these bonds are no longer eligible for cheap financing under the Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF.

“We think that regardless of S&P’s lack of justification for their methodology changes, if they intend to downgrade bonds, then they should get on with it as it will provide investors with some clarity on which bonds they can buy and finance with TALF,” Wheeler noted.

At this point, the market is “getting bifurcated,” Wulf said, adding that TALF-eligible bonds are doing better than the ones that can no longer be bought using the Fed’s cheap loans.

The central bank will offer another installment of these loans on Thursday.

On Tuesday, the GG-10 A4, a benchmark commercial mortgage backed security, was trading about 100 basis points wider than its close of 675 basis points on Monday after it was downgraded multiple notches from the pristine triple-A to just a notch above junk status at triple-B minus, Wulf said.

Two other rating agencies, Moody’s and Fitch Ratings, haven’t cut their ratings on the bond so far.

It is indeed curious that these downgrades coincide with the beginning of CMBS TALF. As I pointed out 5 days ago:

CMBS TALF will be a miserable failure, just as all other lending facilities launched by the Fed. It is possible that this failure will actually expose the dire situation of commercial lenders and accalerate the downward spiral. Thus, look out for the aftermath of first CMBS TALF auction on July 16th. Rather than it being a cure, it is likely that it will usher in a significant acceleration of commercial property loan defaults.

These downgrades may be just one corollary of what I am expecting.


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