Mall Shooting Highlights Folly of Single Asset CMBS Ratings

On Black Friday, the Destiny USA Shopping Mall in Syracuse, New York was evacuated after a shooting in the food court. The following day, a knife fight broke out in the mall’s entertainment complex, adding to shoppers’ apprehension about visiting. This apprehension should be shared by holders of Commercial Mortgage Backed Securities (CMBS) collateralized solely by Destiny USA loans, including owners of $215 million in AAA-rated senior notes. While one short-lived catastrophic event will not lead directly to bond defaults, the outbreaks of violence at an already troubled mega-mall cast a harsh light on rating agency decisions to assign their highest grades to structured notes wholly lacking the protection afforded by diversification.

As Marc reported previously, rating agencies have repeatedly assigned top ratings to CMBS secured by mortgages on only a single shopping mall. These shopping mall deals are a subcategory of so-called Single Asset / Single Borrower (SASB) CMBS. Buyers of AAA-rated SASB securities are protected from adverse performance only by overcollateralization – the fact that subordinated bonds will take the first hit when underlying loans fail to pay interest and principal in full and on time.

In the case of the Destiny Mall deal, JPCMM 2014-DSTY, the S&P and KBRA AAA-rated tranche accounts for half of the $430 million deal (excluding interest only securities). A credit event that forces a write-down of the underlying mortgages by more than 50% will trigger losses on the AAA notes.

While unlikely, such an event is hardly unimaginable, especially given the large number of dead malls dotting the American landscape. Isolated shooting and stabbing incidents – even at the height of the shopping season – probably won’t deliver a large blow to Destiny USA, but if the mall gains a reputation for danger, shoppers will inevitably begin to avoid it. In a weak environment for brick and mortar retail, reduced foot traffic could trigger store closures, leading to a downward spiral of fewer retailers and fewer shoppers.

Without diversification, the senior CMBS notes are vulnerable to default under these circumstances. Facing such a highly plausible default scenario, the senior notes do not justify a rating of AAA – an ultra-safe category for which default should be virtually unimaginable. S&P, for example, claims it expects AAA bonds to have a default probability of 0.15% over any 5-year period.

Why would any rating agency believe a single property, even with multiple businesses on this single property, should have such certainty that a loss of greater than 50% of asset value is virtually impossible? KBRA, for example, acknowledges the low diversity of SASB CMBS but asserts implicitly that its stress assumptions for net cash flow and capitalization rate are sufficient nonetheless.  Yet the stresses at the AAA level apparently do not permit the model to reach 50% loss. Et voila, it’s possible to reach the AAA rating with 50% or lower LTV.

While S&P and KBRA maintain AAA ratings on Destiny USA mall bonds, two other rating agencies take a more critical view of the facility. Both Moody’s and Fitch rate municipal bonds supported by mall revenues. In June, Moody’s downgraded these securities to Ba2 – a speculative rating – citing Destiny’s challenging operating environment. Fitch also downgraded the bonds to BBB concluding that “a recent trend of weaker performance … is likely to reduce the mall's value.”

The top ratings from S&P and KBRA are even harder to comprehend since the CMBS are subordinated to the municipal bonds to which Moody’s and Fitch assign the much lower ratings of Ba2 and BBB, respectively. These municipals are secured by “Payments In Lieu of Taxes” (PILOT) from the mall. According to the Official Statement for these PILOT bonds: “The 2014 CMBS Mortgage securing the 2014 CMBS Loan is subordinate to the PILOT Mortgages securing the PILOT Bonds (Page 4).”

AAA ratings for CMBS bonds that are subordinate to Ba2/BBB municipal securities are very hard to fathom. The distinction of CMBS versus municipal bonds is irrelevant since Dodd Frank’s Universal Rating Symbols mandate requires that rating agencies maintain equivalent meaning of rating symbols across different asset classes. 

A dozen years after the financial crisis, rating agencies remain a weak link in the financial system. We don’t know when the next financial storm will occur or what it might look like, but overrated commercial mortgages are clearly a vulnerability. Before the clouds start gathering, rating agencies should take a harder, more skeptical look at deals collateralized by shopping malls and those collateralized by pools lacking in diversity.

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This piece was written by Marc Joffe and Joe Pimbley, who both consult for PF2.  Marc Joffe is a Senior Policy Analyst at the Reason Foundation. Joe Pimbley is the Editor of the Journal of Derivatives.