05/29/2009

S&P Rating Plan Sparks Industry Firestorm

S&P this week asked the industry to comment on proposed changes to its rating methodology that would result in sweeping downgrades of super-senior, triple-A commercial MBS. The agency may want to brace itself for the response.

The initial reaction came fast and furious, with near-universal condemnation from bondholders, lenders and traders alike. Market participants said they were blindsided by the proposal, which most termed an overreaction by the agency. Some pointed out that the announcement seemed to contradict a previous indication from S&P that super-senior downgrades weren't in the offing. And many questioned S&P's motivation and timing - and warned that the agency is risking a backlash.

The announcement, which amounted to a tacit admission by S&P that its previous methodology was significantly flawed, triggered a huge CMBS selloff on Tuesday, undoing much of the recent rally. Investors worried the shift would torpedo a new Federal Reserve program aimed at jumpstarting the CMBS market by providing low-cost financing to buyers of senior triple-A CMBS.

S&P's new policy, if implemented, would render many of the super-senior bonds issued in recent years ineligible for the Fed program, known as TALF (for Term Asset-Backed Securities Loan Facility). To qualify for financing through the program, bonds can't be rated below triple-A by any agency. S&P said its proposal would likely lead to the downgrade of 25% of super-senior tranches from 2005 transactions, 60% from 2006 deals and 90% from 2007 offerings. Bonds issued during that 3-year period are seen as the ones most likely to benefit from TALF. So far, super-senior bonds, which carry 30% subordination levels, have escaped downgrades.

After blowing out by about 500 bp briefly on Tuesday, spreads on super-senior CMBS recovered much of the loss as investors speculated that the Fed would adjust the terms of TALF so that the long-planned initiative wouldn't have to be scuttled. Spreads ended yesterday at 750 bp over swaps, about 125 bp wider than before the S&P action.

In it 24-page announcement, S&P outlined in detail a series of cross-tests it would apply when evaluating new and seasoned conduit deals. The agency said that one of its goals was to ensure that triple-A bonds could survive "an extreme economic downturn" without defaulting. It said that for a typical new-issue conduit deal, the subordination level for the triple-A portion would rise to 20%. That would be up from the prevailing level of roughly 13% over the past few years.

Not everyone slammed the rating agency. CMBS pioneer Ethan Penner, who oversees an investment program for CB Richard Ellis Investors, gave an impassioned defense of S&P's move as necessary to rebuild the sector (see article at right).

After the initial criticism, S&P strongly defended its proposal as warranted by its analysis of market conditions. "We take actions, including criteria changes, when we feel they are appropriate," said spokesman Ed Sweeney.

Sweeney disputed the notion that the announcement was an admission that S&P's previous guidelines were flawed. "Ratings are forward looking and evolve as the environment changes and our views about future performance changes," he said.

While investors acknowledged that rating methodologies need to be amended in light of the market debacle, many asserted that S&P's proposed policy was overly harsh. "S&P's sudden move to reinvent the wheel, with exaggerated cashflow and default probabilities - which appear to be somewhat arbitrary - creates an unrealistically high standard for triple-A risk and will make the cost of new issuance very prohibitive," said Brian Phillips of money manager AllianceBernstein.

"I think it is an enormous overreaction," said a portfolio manager at a big life insurance company who did not want to be named.

One veteran CMBS trader was scathing in his criticism. "They screwed it up going into the cycle," he said, "and now they are screwing it up coming out of the cycle. They never get it right."

Some bristled at the suddenness of the announcement and the fact that S&P initially allowed only one week for comments, setting a June 2 deadline. "People are very angry because none of these bonds were on watch," said one veteran executive at a CMBS dealer. "And it's egregious for them to say, we'd like comments that are going to impact all these bonds, and you have only one week to comment, and for them to have a poorly defended analytical framework."

Late yesterday, S&P extended the comment deadline to June 9 in response to complaints from the industry. Also, the S&P spokesman noted that the agency had issued an "advance notice of proposed criteria change" in December 2008 that laid out the agency's concerns about deteriorating performance of CMBS and signaled an upcoming change.

Several CMBS players cited an April 6 S&P report saying that "the majority" of mezzanine triple-A bonds "are likely not at risk for downgrade" under the agency's "baseline," or expected, outlook. They said they had interpreted that as a sign that super-senior bonds were largely safe from downgrades.

The S&P spokesman said "the April scenario analysis never served as rating criteria, but was meant to test the resiliency of our ratings under different economic environments under our existing criteria."

Much of the criticism centered around the timing of the announcement, not only because it came so late in the economic downturn, but also because it took place only one week after the Fed provided details of how TALF would work with CMBS purchases. That Fed announcement added fuel to an ongoing rally spurred by expectations the government's involvement would revitalize the sector - momentum that was reversed by the S&P move.

Numerous investors and traders were incredulous that S&P didn't at a minimum make its announcement before the terms of the Fed program were released. "What's the point of doing this now?" Phillips asked. "This move is simply not constructive on their part, and puts the credibility of their rating process into question."

Added a bondbuyer at an insurance company: "To change the methodology at this point in the game seems irresponsible."

The S&P spokesman didn't directly respond when asked if S&P had been in touch with the Fed in advance of the announcement, but noted that the agency formulates policies "independent of other concerns." He added: "We do not control how investors use our ratings and have not advocated for inclusion of our ratings in any regulation or guideline."

One frequent refrain among market players was the notion that the rating agencies have collectively lost the market's trust as the financial collapse has played out. Critics contended that this week's action by S&P made matters worse, not better.

"We view S&P's release as an extreme example of a procyclical overreaction, one that may reinforce investors' skepticism and could ultimately cause them to question the relevance of the rating agencies as part of the investment process," said Alan Todd, chief CMBS analyst at J.P. Morgan.

The motivation behind S&P's move was the source of much speculation. Few market players seemed willing to accept at face value the agency's contention that the proposal was simply the result of a long-running, in-depth review of its methodology in light of the market downturn.

Some viewed the announcement as an effort by David Jacob and Mark Adelson, the former Nomura executives brought in last year to assume senior posts at the agency, to put their stamps on the organization and make a clean break from the past.

"It almost strikes me that what S&P is doing is what you see a lot in the corporate world, when new management comes in after a blow-up," said Larry Grossman, who oversees CMBS investments for Hypo Real Estate. "They say, 'All these problems were the old management's fault, it wasn't us.' "

Others suggested that S&P was seeking to distinguish itself from rival agencies and position itself for a revival of CMBS activity. "A cynic might conclude that S&P's actions are perhaps motivated not purely by market fundamentals, but also by the evolving competitive landscape in the rating business," said Derrick Wulf, fixed-income portfolio manager at Dwight Asset Management.

A couple of days after S&P's announcement, there was growing speculation among investors that the Fed would adjust its rules for TALF so that super-senior bonds from most deals floated between 2005 and 2007 would still be eligible. "The government can, and has in the past, changed the rules, so we will probably see a 'TALF 2.0' eventually," Grossman said. A Fed spokeswoman declined to comment.

Back Print