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Underwriter and Rating Agency Issues in Securitized Loan Transactions

Underwriter and Rating Agency Issues in Securitized Loan Transactions. Presented to ICSC 2002 Law Conference David W. Forti, Dechert Michael Weinberger, Cleary Gottlieb, Steen & Hamilton October 24, 2002. Overview. Role of Rating Agencies What is a rating Why are ratings necessary

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Underwriter and Rating Agency Issues in Securitized Loan Transactions

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  1. Underwriter and Rating Agency Issues in Securitized Loan Transactions Presented to ICSC 2002 Law Conference David W. Forti, Dechert Michael Weinberger, Cleary Gottlieb, Steen & Hamilton October 24, 2002

  2. Overview • Role of Rating Agencies • What is a rating • Why are ratings necessary • Rating Agency methodology • CMBS rating methodology • Floating rate loan and single borrower deals Underwriter and Rating Agency Issues in Securitized Loan Transactions

  3. Overview • Rating Agency surveillance • Post-closing surveillance of transactions • Rating actions Underwriter and Rating Agency Issues in Securitized Loan Transactions

  4. Role of Rating Agencies:What is a CMBS Rating • Ratings are assessments of likelihood that bond holders will receive timely payment of interest, and ultimate payment of principal by the rated final distribution date of a deal - some period of time beyond the last maturity date of loans Underwriter and Rating Agency Issues in Securitized Loan Transactions

  5. Role of Rating Agencies:What is a CMBS Rating • Three national statistical rating agencies routinely rate CMBS deals - Moody’s, Standard & Poor’s and Fitch. Most CMBS deals have at least 2 rating agencies • Each tranche of bonds in deal will have its own rating Underwriter and Rating Agency Issues in Securitized Loan Transactions

  6. Role of Rating Agencies:Investment Grade Ratings Underwriter and Rating Agency Issues in Securitized Loan Transactions

  7. Role of Ratings: Subordination • Real estate loans rarely possess attributes necessary to support highly rated bonds; subordination of classes of bonds is used as credit enhancement on CMBS deals • Subordination shifts risk of non-payment to more junior classes Underwriter and Rating Agency Issues in Securitized Loan Transactions

  8. Role of Ratings: Subordination • In evaluating deals, rating agencies determine the levels of subordination, i.e., the amount of bonds that must be subordinate to each tranche to support particular rating • Issuer’s goal is to have lowest subordination levels possible Underwriter and Rating Agency Issues in Securitized Loan Transactions

  9. Role of Rating Agencies: Why Are Ratings Necessary • Investment in CMBS transactions is significant source of capital for commercial real estate lending • Understanding credit risk embedded in each CMBS deal is complex and time consuming - multiple loans; each is unique Underwriter and Rating Agency Issues in Securitized Loan Transactions

  10. Role of Rating Agencies: Why Are Ratings Necessary • Investors in investment grade bonds often lack time and real estate expertise to do detailed analysis • Ratings provide mechanism for matching CMBS bonds with particular investor risk tolerance Underwriter and Rating Agency Issues in Securitized Loan Transactions

  11. Rating Agency Methodology • In evaluating deals, rating agencies do individual loan analysis and portfolio or “pool” analysis Underwriter and Rating Agency Issues in Securitized Loan Transactions

  12. Rating Agency Methodology • Individual loan analysis considers credit-worthiness of individual loans, including underwritten cash flow, cash flow volatility, tenant quality, anticipated rollover, property type, quality, location and competitiveness, borrower and manager reputation, market conditions, loan structure and amortization Underwriter and Rating Agency Issues in Securitized Loan Transactions

  13. Rating Agency Methodology • Portfolio analysis considers credit-worthiness of entire pool on aggregate basis, including pool size, number of and size of loans, property types, overall property quality, and concentrations, including by borrower, property type and location Underwriter and Rating Agency Issues in Securitized Loan Transactions

  14. Rating Agency Methodology • In reviewing pools, rating agencies typically conduct a full file review of large loans, and a random sample of other loans Underwriter and Rating Agency Issues in Securitized Loan Transactions

  15. Rating Agency Methodology:Individual Loan Analysis • In evaluating individual loan, rating agencies typically re-underwrite stabilized net cash flow for collateral property, using rating agency’s criteria for determining sustainable net cash flow, which is “capped” to determine stabilized value of the property Underwriter and Rating Agency Issues in Securitized Loan Transactions

  16. Rating Agency Methodology:Individual Loan Analysis • Values are used to determine DSCR and LTV ratios for loan • Rating agency underwriting criteria and capitalization rates often more conservative than market Underwriter and Rating Agency Issues in Securitized Loan Transactions

  17. Rating Agency Methodology • General model for determining CMBS subordination levels has 3 main components - default probability, loss severity and pool composition • Individual loans quantified using DSCR and LTV ratios to assess default probability and loss severity Underwriter and Rating Agency Issues in Securitized Loan Transactions

  18. Rating Agency Methodology • May be adjusted for property/loan features likely to impact default probability or loss severity, including environmental conditions, applicable state foreclosure practice, subordinate indebtedness and presence/absence of loan provisions, such as lender-controlled cash management, escrow requirements, and bankruptcy remote borrowers Underwriter and Rating Agency Issues in Securitized Loan Transactions

  19. Rating Agency Methodology • Pool composition is evaluated to determine concentrations of risk • Pool diversity (borrower, property, type, location) analyzed to determine if performance of otherwise unrelated loans may be highly correlated to one another Underwriter and Rating Agency Issues in Securitized Loan Transactions

  20. Rating Agency Methodology • Pool size and loan size analyzed because small pools or pools with disproportionately large loans concentrate risk Underwriter and Rating Agency Issues in Securitized Loan Transactions

  21. Rating Agency Methodology • Subordination levels can be further affected by deal structure issues, such as unusual bond structures, quality of loan representations made by depositor, and unusual PSA provisions Underwriter and Rating Agency Issues in Securitized Loan Transactions

  22. Rating Agency Methodology • Once analyses complete, rating agencies determine subordination levels for pool, i.e., the aggregate amounts of bonds that will qualify for particular ratings • Some classes of bonds may be unrated, meaning that issuer has requested rating agencies not to rate those bonds Underwriter and Rating Agency Issues in Securitized Loan Transactions

  23. Rating Agency Methodology:Floating Rate Loans • Modeling floating rate loan pools requires evaluation of additional factors, because floating rate loans often interest only balloon loans, and may be higher leveraged short-term loans Underwriter and Rating Agency Issues in Securitized Loan Transactions

  24. Rating Agency Methodology:Floating Rate Loans • Interest rate risk, little or no amortization, and higher leverage increase default and loss severity probabilities, which may result in higher subordination levels • Interest rate risk can be mitigated with interest rate cap agreements Underwriter and Rating Agency Issues in Securitized Loan Transactions

  25. Rating Agency Methodology:Single Borrower Transactions • Evaluating single borrower CMBS transactions is similar to other CMBS transactions, except that all credit risk is concentrated in one borrower • Single borrower transactions may be a single large asset, or pool of cross-collateralized assets Underwriter and Rating Agency Issues in Securitized Loan Transactions

  26. Rating Agency Methodology:Single Borrower Transactions • Because no diversity in single asset deals, transactions much have extraordinary credit quality, including property quality, market position, borrower and management expertise, loan structure and leverage to support highest rated bonds Underwriter and Rating Agency Issues in Securitized Loan Transactions

  27. Surveillance • Surveillance is the post-closing monitoring of CMBS transactions by rating agencies • Purpose of surveillance is to ensure that ratings of bonds accurately reflect current investment risk, and provide information to investors regarding performance of CMBS deals Underwriter and Rating Agency Issues in Securitized Loan Transactions

  28. Surveillance • Surveillance teams monitor information provided by servicers about each deal, including review of collateral performance of large loans and statistical pool-level review of conduit loans, as well as evaluation of current pool composition and characteristics Underwriter and Rating Agency Issues in Securitized Loan Transactions

  29. Surveillance • Surveillance also involves review of post-closing borrower requests involving changes to loan components originally evaluated by rating agencies, including equity sponsorship, subordinate indebtedness and property management Underwriter and Rating Agency Issues in Securitized Loan Transactions

  30. Surveillance: Rating Actions • Bond ratings may be adjusted at any time to respond to performance trends (positive or negative) which change credit risk for a particular tranche of bonds • Affirmations of ratings occur when a transaction has performed as expected with no significant delinquencies or problems Underwriter and Rating Agency Issues in Securitized Loan Transactions

  31. Surveillance: Rating Actions • Upgrades of ratings occur most often when there is increased credit support in a pool, though negative changes in pool composition may negate the effect of such enhancements • Downgrades of ratings generally result from actual or projected losses that are higher then originally anticipated Underwriter and Rating Agency Issues in Securitized Loan Transactions

  32. Surveillance: Rating Actions • Within a deal each tranche is reviewed, and rating changes may affect some classes of bonds but not others • Because of subordination feature of CMBS bonds, senior bonds are most often upgraded and junior bonds are most often downgraded Underwriter and Rating Agency Issues in Securitized Loan Transactions

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