The COVID-19 virus is likely going to have an especially severe impact on commercial mortgage-backed securities (CMBS), bonds that are backed by mortgages on non-residential properties. According to data from DBRS Viewpoint, more than half of the mortgages in CMBS deals are on offices, hotels and retail buildings— three categories especially hard hit by shelter-in-place orders issued during the coronavirus pandemic.
If shelter-in-place restrictions are lifted quickly and everything gets back to normal immediately, most of these properties would probably be able to continue servicing their mortgages. But, if the U.S. is instead entering a new normal of telecommuting, reduced travel, and increased online shopping, then thousands of office buildings, hotels and malls are at risk of default.
This potential default wave would first expose the folly of poorly structured, over-rated CMBS deals. On the ratings side, the reckoning began on March 20, when Standard and Poor’s downgraded 60 bonds in 15 deals with concentrated retail exposure. In its downgrade announcement S&P stated, “While COVID-19 will likely have an accelerated effect on performance declines for properties with retail exposure, today’s rating actions do not specifically address the outbreak of the virus.” So further ratings “adjustments” may occur once the full retail impact of the coronavirus is understood.
The most dramatic downgrades were meted out to poorly diversified single-asset/single-borrower securities that Joe Pimbley and I highlighted in a previous Wolf Street article, which focused on AAA securities backed by two mortgages on Destiny USA, a mega-mall located in Syracuse, NY. That mall is partially closed until further notice. S&P has now reduced the ratings on these bonds by five notches to A.
S&P dealt an even steeper downgrade to another single borrower deal: Starwood Retail Property Trust 2014-STAR. This CMBS transaction is backed by mortgages on four shopping malls owned by Starwood Retail Partners. Although geographically diversified, three of the four malls have lost anchor tenants. Starwood wrote down the value of its investment in the four properties by nearly 50 percent last May and payment defaults on the underlying mortgage began in November, suggesting that S&P’s action is not especially timely. S&P made up for its tardiness by downgrading the AAA notes nine notches to BBB-, just one notch above junk. S&P stated:
Although we believe the credit risk on class A has increased, we also believe its senior position in the waterfall somewhat mitigates principal losses and interest shortfalls concerns; and, as a result, we opined that the certificates continue to exhibit the credit characteristics of a low-investment-grade rated security. However, if there are any reported negative changes in property performance beyond what we have already considered, we may re-visit our analysis and adjust the rating as necessary.
Thus, S&P has left the door open to quickly downgrade the security into junk territory as the coronavirus situation evolves. Potential buyers of this security would have been better served by more active monitoring of this deal, which would have resulted in several smaller downgrades, rather than the sudden markdown of a supposedly risk-free security to the precipice of high-yield.
But rating agencies have little incentive to perform the necessary monitoring. They are paid by deal issuers and competitively dumb down credit standards to get issuer business. They also receive pressure from the owners of securities who hate to see downgrades, which may necessitate markdowns or forced sales of instruments in their portfolios (since some asset managers require their holdings to be at or above a certain rating).
To S&P’s credit, they have been faster to recognize their folly than other agencies. As of March 22, for example, Kroll Bond Rating Agency still rated the Destiny USA senior notes at AAA. And DBRS Morningstar Ratings showed the Starwood 2014 senior notes at AAA. It appears the newer, smaller rating agencies are not yet improving the rating business’s surveillance capabilities.
Although the bond issuers and credit rating agencies could not be expected to predict the coronavirus pandemic, they should not encourage the creation of AAA securities that are so exposed to event risk. A single property is not only vulnerable to pandemics, but to a wide range of events, including terrorist attacks, weather catastrophes, and even the financial distress of anchor tenants such as Macy’s.
But the overrating of poorly diversified CMBS securities continued right up to the start of the coronavirus outbreak. On March 5, Moody’s and DBRS Morningstar both assigned provisional AAA ratings to Class A certificates issued by BX Commercial Mortgage Trust 2020-VIVA. This deal is collateralized by a mortgage on the MGM Grand and Mandalay Bay resorts in Las Vegas. With the Las Vegas strip closed indefinitely, one has to wonder how that will work out.