The IO Abbatoir

As we noted in December, Moody's decided to catch up to the rest of the rating agencies (who did the same thing 2 and 3 years ago) and the rest of the market, which apparently understood IOs eons before the rating agencies by publishing a new opinion and methodology piece and downgrading 530 IOs (almost all were WAC IOs).

If you missed the Moody's report, Nomura published a great paper this morning that sums it up neatly in 2 pages.

[sarcasm>The WSJ has been closely following the coming WAVE of downgrades, so we look forward to their coming article on the subject.

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.

Floater downgrades coming

Not unexpected, but Fitch stated that they would finally start taking action on $27bln Floaters put on RWN in December...

My favorite is their sophisticated model analysis

loans will be assumed to default during the term if the stressed cash flow would cause the loan to fall below 0.95 times (x) debt service coverage ratio (DSCR) or at maturity if the loan can not meet a refinance test of 1.25x DSCR based on a property specific refinance rate of 8% to 9% on a 30-year amortization schedule

I love comments like that - makes you wonder what's on the inside of the model

Coming and Going

We have a lot of Treasury auctions this week, retail sales, gas. Most importantly, Wednesday is an recommended close for Veteran's Day, and I'm looking forward to watching the little cars with big guys in red fez hats zipping around on our little village's Main Street drag (or is that Memorial Day - I think I may end up being very disappointed if there are no fez's on Wednesday).

Spreads gapped wider for the week. There was a lot of selling as folks took profits off the table for the year, and very little buying as the same folks are waiting to see what kind of allocation they'll get for 2010. The holiday doldrums seemed to have started a few weeks early this year.















It felt like there was a huge uptick in downgrade activity this week, but I think it was just in the MSM a little more than usual. Within domestic CMBS, there were 280 rating actions last week, just slightly below the average 309 actions per week since August 1st. They were mostly negative with no upgrades, and just 8 cases where the watch status improved. S&P has always been the dominate CMBS rating agency, but they have been substantially more active (869 actions since 8/1/09) than either Moody's (302) or Fitch (646). The deals that had downgraded are listed below:

WBCMT 2007-C31
WBCMT 2007-C30
WBCMT 2006-WL7A
MLCFC 2007-5
JPMCC 2006-LDP7
GCCFC 2007-RR2
CSMC 2007-C4
CSFB 2001-SPGA
MSC 2005-T17
MLMI 1999-C1
JPMCC 2006-LDP8
CSFB 2005-TF2A
WBCMT 2005-C21
CSFB 2005-C4
BSCMS 2006-BBA7
BACM 2007-3
WBCMT 2006-C28
STRIP 2004-1A (these are some old ReREMIC deals mostly 3yr old A1s and A2s)
STRIP 2002-2A
STRIP 2002-1A
STRIP 2003-1A
MLCFC 2007-9
CMLT 2008-LS1

S&P Slaughterhouse 5 Continues

BN 12:14 *S&P SAYS AFFIRMED CLASSES HAVE PAR BALANCE $249.8B
BN 12:14 *S&P SAYS RELATED SECURITIES HAVE PAR BALANCE OF $235.2B
BN 12:13 *S&P PUTS 1,584 US CMBS RTGS ON WATCHNEG; 1,394 'AAA' RTGS AFMD

Rating Actions

Over 3,000 year-to-date! Compares to just over 1,000 for all of 2008, and less than 200 in every year prior back through the turn of the century.

S&P Delivers Another Right Hook

Under our 'AAA' stress, losses from this vintage range from 12.3% to 60.4%, but these loss rates are commensurate with an extreme economic downturn and do not represent our expected case.

Ten-year super-duper (30% credit-enhanced) classes have a higher potential for downgrades than the shorter weighted-average life classes. The ratings on older vintages (2000-2004), which were issued well before the peaks in valuations (2007) and effective rents (2008), and generally utilized stricter underwriting standards than more recent vintages (2005-2008), saw less downward movement on average in our analysis.

S&P Places 2,648 classes on Watch - Over 100 are AAAs

S&P placed over 100 CMBS AAAs including 20% super seniors, AJs, and IOs on Rating Watch Negative this morning.

Again, this is not unexpected and is in fact an extremely delayed reaction on their part. The 20% super seniors (these are prior to the 30% super dupers - I hate that word) are a bit of a surprise, but not really. I expect this will reign in some of the tightening temporarily, but look for spreads to continue their momentum tighter until some truly bad news regarding CRE starts rolling in.

These little tidbits about 15% price declines, John Hancock, and 1.8% delinquency rates aren't really *bad enough* to drive prices lower than the already distressed prices in the market. Frankly, PPIP et. al. are not good enough to whip prices higher at a faster pace either.

S&P Prepping For Wave of Downgrades - Surf's Up!

S&P says recent US CMBS highly susceptible to cuts

Mon Apr 6, 2009 3:22pm EDT

NEW YORK, April 6 (Reuters) - Standard & Poor's on Monday said it will make negative pronouncements on U.S. commercial mortgage-backed securities on a "large scale" in coming days after a review of the securities.

The most-recently issued CMBS are "highly susceptible" to downgrades, including top-rated "AAA" issues, after the review that accounted for eroding real estate markets, lack of financing for the assets, and the economic recession.

Moody's completed downgrades

Following 7 days of correcting their ratings on 1,422 bonds worth over $50 billion, Moody's stated it was done with its review. The actions were highly anticipated for some time, and made for a volatile market the last two weeks.

Obviously, Moody's made a huge mistake - they are not downgrading these due to deterioration in quality, but rather due to changes in their model. And their new model is only calling for 5% losses on recently issued deals with the weakest credit profiles. Historical losses when times were good are 3%! I don't know how they are still in business.

Publish Post

PCV/ST Deals Downgraded

How prescient. Deal Junkie brought a lengthy article on PCV/ST to our attention this morning, and by this afternoon Moody's had started it's wave of mutilation in CMBS due to the same transaction. The Aaa-rated AJ class was downgraded to A2...

Frankly, I don't think it was unexpected and I figured it was mostly priced in, but it is putting surprising pressure on spreads.

Run for the Hills!!!! AAA Downgrades are coming...

Not sure if that is Tad Philipp enjoying his new found freedom on the buy side, or Nick Levidy chasing a couple of the weaker AAA broads bonds through the valley as he thins the herd.

Moody's is going to whack AJs down half a dozen notches over the next couple of months according to a release to day.

the junior Aaa-rated classes, to be downgraded by four to five notches on average.

Expect losses of just 5% on average (seems low).

Moody's generally rated conduit and fusion transactions from 2006 through 2008 to an expected loss of about 2%, but now expects that deals from these vintages will experience losses of approximately 5% on average.

Credit problems on the horizon? Who'da'thunk...

"Early in the current economic crisis, our biggest concern was the impact of a liquidity crunch on commercial real estate," says Moody's Senior Vice President, Michael Gerdes. "However, Moody's now expects a significant overall decline in property cash flows as a result of a higher incidence of tenant defaults and bankruptcies and a sharp decline in lease renewal rates."