Friday, December 2, 2011

Moody's taking CMBS IOs to the finishing lot

Moody's announced it was planning on rating IO tranches to more accurately reflect the inherent credit risk in CMBS IOs. S&P took a similar stance in 2009, and Fitch started withdrawing many IO ratings in 2010.

If you're unfamiliar, IOs in the CMBS world are comprised of the leftover interest in a deal - in other words, the difference between the weighted average net mortgage rate and the weighted average coupon of the CMBS bonds. If the underlying mortgages have a coupon of 5% and the WAC of the CMBS is 4.75%, then there is a 25 bp excess interest cash flow that goes into the IO. This was sometimes split instead into a PAC and a support IO. The IO also typcially gets all or part of the prepayment penalties.

Because the cash flow stream is so thin and there is no principal cash flow to IOs at all, these typically trade in single digits regardless. But, there is roughly an IO notional balance that equals the total size of the universe (they quote $600bln in the sell-side research and WSJ articles, but they're missing big parts of the universe... likely Ginnie Mae Project Loan deals for one.).

Obviously this interest cash flow stream can be interrupted by prepayments, defaults, modifications, various fees, and ASERs. The rating agencies are basically conceding that when they originally rated IOs, they only measured ratings against prepayments and gave credit back for prepayment penalties.

Will this REALLY impact prices?
On the one hand, I would be astounded if a ratings downgrade that has been widely anticipated since at least early-2009 and talked about in years prior to the meltdown would force a massive sell off. Does anyone even use ratings any longer? On the other hand, it wouldn't really surprise me that something widely anticipated and expected still caused a sell-off in CMBS-land. However, IOs are already treated as non-AAA securities by many regulators and most investors, so we really need substantial downgrades (from AAA to nonIG) to force selling.

Although small and mid-sized banks are not big players in CMBS, there are some that are active and they probably will sell any IOs that fall below investment grade (even AAA-rated IOs are treated with the same risk based weighting as a BBB cash bond by the FDIC, so a single notch downgrade will not force the bank's hand).

Some institutional investors will have investment grade/non-investment grade criteria that still causes them to unwind positions as well. Insurers (the vast majority of the legacy CMBS investor base) are less likely to sell off IOs en masse, IMHO, though, because they already rely less on ratings than their new risk-based modeling performed by PIMCO and Blackrock. Mutual Funds on the other hand may be forced to sell off.

I pushed the button earlier, and it didn't do anything. I was tempted by the possiblities for days but was too timid at first, finally abdicating earlier today and smashing it down, only to be overwhelmed with disappointment.

Buy or Sell?
I for one hope it does cause a sell-off so I can pick up some IO bonds. I actually have bought a few (both off Conduit and Project Loan deals) over the last several years that have performed beyond my expectations. I'm still surprised, generally in a positive way, when I get a little unexpected cash flow off of one of these. The real hard part is buying them cheap enough - beat the hell out of collateral and still get really good double-digit returns (even triple-digit if you're lucky) - that hasn't been possible as much in 2011 as it was in the prior 2 years. Hopefully 2012 will give us some more good cheap pricing.

Where can I find out more?
One can derive the most entertainment and get the most information about this move by reading the overly sensationalized WSJ article on the matter, which misinterprets a sell-side research report (coincidentally? authored by a former rating agency analyst) from Deutsche Bank. BAML issued a report a few years ago that described them in detail, but I can't find it online (the image above is cut from it though). I'd be happy to email it to someone if they're interested, so just let me know.


crabsofsteel said...

Don't mean to rain on your parade, but Julia pointed out that any covenant-based holders would have already sold because they required ratings from two agencies and the other two have already bailed. I'm with you on picking them up cheap; regardless of ratings agency shenanigans they are structurally superior to mezzanine cash bonds which are almost certainly IOs yet are being priced in the double digits.

Dark Space said...

I agree - I think my comments above agree too.

The only real potential sellers are small to medium sized banks - they're investment policies are looser and very different from bank to bank. The only regulator driven policy they have to consider is the one that is specific to interest-only bonds, which is not ratings based, but effectively treats them like a BBB. Downgrades below BBB may still force them to sell here. Many banks do not require "at least two ratings" either, so this was not an issue for them to start with.

Do insurance companies even take ratings into consideration at all anymore? I'm honestly not sure, but know that they play a very diminished role.

Anonymous said...

Not sure I agree with the comment that everyone that had to sell has sold already. S&P did not downgrade or withdraw ratings on legacy deals and Fitch withdrew the rating. If Moody's downgrades there maybe some (small forced selling).

Unfortunately while we would like to buy them cheap on any downgrade, forced selling does not necessarily mean a big price change.

As the team at CS pointed out the bigger buyer of IOs lately is non-rating constrained accounts, like ourselves, so any selling as a result will be absorbed easily.

crabsofsteel said...

What insurance companies did was to substitute their own NAIC ratings for those of the agencies. I was thinking more of pension funds as covenant-based forced sellers, but I don't know how involved they got in IO space.