Can Technology Freshen Up Stale CMBS Ratings?

Sears' recent bankruptcy filing underscored the challenges confronting shopping malls in the late 2010s. Because mortgages on these facilities often account for the lion’s share of CMBS asset pools, shopping mall performance needs to be top of mind for those analyzing (or rating) CMBS tranches.

New technology – originally targeted at investors analyzing retail sector stocks – might also be applicable to CMBS analysts.

Foot Traffic

Consider, for example, Advan Research. The company processes billions of daily foot traffic measurements from cellphone applications, and computes foot traffic data pertaining to 1,800 companies including both retailers and Real Estate Investment Trusts. Since many REITs own shopping malls, the company collects foot traffic data for these retail centers.

I asked Advan for data on a mall discussed in a previous post. A mortgage on The Mall at Stonecrest in Lithonia, Georgia accounts for almost all of the remaining collateral supporting Banc of America Commercial Mortgage Series 2005-1. Fitch rates the most senior remaining tranche, Class B, at Single-B. S&P assigns the same tranche a low investment grade rating of BBB-. 

Who’s right? The data from Advan suggests a downward trend in foot traffic at Stonecrest, as shown in the accompanying chart. Average estimated visitors for the five Saturdays in July 2017 were 19,816; for the five Saturdays falling 52 weeks later, the average fell to just 12,659. On the other hand, a similar comparison between October 2017 and October 2018 shows only a slight drop, suggesting that perhaps the decline in visits has been arrested. 

To the extent that Advan’s data can be relied upon, it seems to give us a more recently refreshed gauge on the shopping mall’s health than other data sources. Certainly, the trustee report is not giving us up-to-date guidance. The November report includes the following special servicer comments: 

Modification closed and funded 8/5/2017. The loan is currently paying as agreed. The loan matures in 8/2018 and the Borrower advises that the proposed adjacent 100 acre sports project has been put on hold due to lack of funding. Although the collateral is 97% occupied, the dark Kohl's and Sears may trigger some co-tenancy issues. The Borrower advises it is in the market seeking refinancing, but due to the current situation with the sports project and 2 dark anchors, refinancing may not be sufficient to pay off the loan in full at maturity. The Borrower has engaged CREMAC to aid it in its workout negotiations with the Lender/Special Servicer. A new appraisal has been ordered and received. Valuation is under review. Maturity Date extend to 8/1/18; principal reduction in the amount of $1,233,073.95 for a balance of $92,066,680.26; no change in rate of 5.603%. 

These comments do not appear to have been revised since the most recent term extension for the Stonecrest mortgage which was through August 1, 2018.

Social Media and Other Sources

In addition to reviewing foot traffic, analysts can monitor the web and social media for news about relevant shopping malls. For example, a local newspaper, the Springfield News-Sun, reported that nearly 100 cars in the mall’s parking lot were broken into on October 5, 2018. A nail salon employee at Stonecrest argued that the mall does not provide video surveillance of the parking lot, making it harder to identify and apprehend any wrongdoers. A search for #stonecrestmall on Twitter reveals that a shooting occurred at the center – but it took place three years ago.

While it is possible to use free tools like Google Alerts to monitor individual shopping centers, that approach might not scale well to a large portfolio. Specialized search services like Bitvore (for which I used to consult) enable analysts to track news on large numbers of positions, even allowing news searches by CUSIP number.

Cell phone activity, web content and social media posts offer new ways for rating agencies and other analysts to track CMBS mall collateral real time. Finding or compiling the nuggets of useful data from these information streams is a challenge that new technology firms can help solve.


--------------------------------------------

This piece was written by Marc Joffe, who consults for PF2.  Marc Joffe is a Senior Policy Analyst at the Reason Foundation and a researcher in the credit assessment field. 

S&P Maintains Investment Grade Rating on CMBS Tranche Mainly Collateralized by a Defaulted Loan

The Class B notes of Banc of America Commercial Mortgage Series 2005-1 (BACM2005-1) are currently collateralized by two commercial mortgages.  

One of these mortgages, a $92 million loan on the Mall at Stonecrest in Lithonia, GA accounts for 96.9% of the collateral pool and is in “special servicing” – a fancy name for workout. Yet S&P maintains an investment grade rating of BBB- on this risky instrument.

The most recent remittance report on BACM 2005-1 (available at CTSLink) includes the following language with respect to the Mall at Stonecrest mortgage:

The loan matures in 8/2018 and the Borrower advises that the proposed adjacent 100 acre sports project has been put on hold due to lack of funding.  Although the collateral is 97% occupied, the dark Kohl's and Sears may trigger some co-tenancy issues.  The Borrower advises it is in the market seeking refinancing, but due to the current situation with the sports project and 2 dark anchors, refinancing may not be sufficient to pay off the loan in full at maturity.  The Borrower has engaged CREMAC to aid it in its workout negotiations with the Lender/Special Servicer.

The “sports project” mentioned in the report is Atlanta Sports City, a 200-acre sports and entertainment complex planned for a plot adjacent to the mall.  If and when Atlanta Sports City opens, it will presumably generate substantial foot traffic in the vicinity of Stonecrest.  But construction has been delayed and there is no clear timeline for completing the project, leaving a large vacant parcel next to the mall for the time being.

Since the servicing note quoted above is dated September 4 and the maturity date was August 1, the Stone Crest loan would appear to be in default. This default follows an August 2017 loan modification at which time the maturity date was extended and principal was reduced by over $1 million.

So how can a CMBS tranche backed almost entirely by a defaulted shopping mall loan be investment grade?  Well, the Class B notes do benefit from “overcollateralization”: two subordinated bonds would absorb losses on the loan before the BBB- class is impacted.

Fitch appears to have a less sanguine view of this overcollateralization benefit:  they rate the notes at single B – deep into junk territory. In its latest update, Fitch reported:

The overall mall and collateral occupancy have continued to decline. As of the September 2017 rent roll, overall mall occupancy declined to 76.1% (from 85.5% one year earlier) after Sears vacated its 145,000sf non-collateral store in January 2018.

S&P’s relatively high rating could be the result of insufficient monitoring, an overly sanguine view of shopping mall collateral or some combination of both.

S&P’s last report on BACM 2005-1 is dated March 2, 2018. The write-up does not refer to press reports about the delay of Atlanta Sports City, so it is unclear whether this news was considered. Further, the certificates have not been downgraded, placed on watch or assigned a negative outlook since the latest remittance report appeared. Since that report indicates that the Stonecrest mortgage was neither repaid nor refinanced by its August 1, 2018 maturity date, some rating action would appear to be warranted.

Overrated Shopping Mall CMBS

In 2015, I argued strongly against inflated credit ratings on Commercial Mortgage Backed Securities, especially those with a collateral pool consisting of a single shopping mall loan. Because they lack diversification, such deals expose investors to event risk inconsistent with the AAA ratings assigned to the senior tranches in these deals.

With six NRSROs competing for generous fees on rating CMBS transactions, the ability for deal underwriters to engage in rating shopping is high and the incentives for rating agencies to lower their credit standards is strong. Assigning inflated ratings in any one asset class violates Dodd Frank’s universal rating symbol mandate, according to which symbols must have the same risk implications across all asset classes. Moody’s was recently sanctioned by the SEC for its apparent failure to apply universal rating symbols when rating CLO Combo Notes.

Although none of the single mall deals I listed in 2015 has experienced credit events thus far, they have yet to be tested by a recession.  In the meantime, we have seen abundant evidence that shopping malls are vulnerable. Brick and mortar retail faces a stiff challenge from Amazon and other online retailers. Several national retail chains have filed for bankruptcy or announced large-scale store closures, creating mall vacancies.

Back to BACM

Although BACM 2005-1 launched with a diversified portfolio securing the issued notes, it had a heavy retail weighting – loans in this category comprised 35.8% of the initial collateral pool. The Class B certificates received initial ratings of AA from both S&P and Fitch, levels that proved too optimistic given the performance of the collateral pool.

Thus far the deal has realized $193 million in cumulative losses, representing 8.4% of initial collateral. The failure of Stonecrest Mall SPE to pay off its loan on the original maturity date of October 1, 2014 has left Class B investors in the deal for a much longer duration than originally expected. This bond’s estimated final distribution date was March 10, 2015 according to the original prospectus.

What remains now closely approximates a single asset CMBS, but one with distressed collateral. Class B will probably pay off in full at some point since junior notes are available to absorb some amount of additional write-downs. But ratings are supposed to reflect a greater level of precision than the word “probably” communicates.  According to S&P, obligations rated 'BB', 'B', 'CCC', 'CC', and 'C' are regarded as having significant speculative characteristics. That seems to be a fair description of the BACM 2005-1 Class B notes.


-------------------------------
This piece was written by Marc Joffe, who consults for PF2. Marc is a Senior Policy Analyst at the Reason Foundation and a researcher in the credit assessment field. 

Government Credit Crisis is Over - So Where are the Ratings Upgrades?

The sovereign and municipal debt crisis of the early 2010s is finished. Overblown predictions of a credit meltdown among European sovereigns, US states and cities, and other advanced economy governments have not been realized. Yes, there have been a few high profile defaults - Greece, Detroit, Harrisburg, Stockton and San Bernardino all come readily to mind because their insolvencies received so much coverage. But many other predicted defaults – Italy, Spain, California, Illinois, San Jose – failed to materialize and the overall default rate among government issuers has been only a few basis points annually. Meredith Whitney’s 2010 forecast of dozens of major municipal defaults is now fully beyond resuscitation – even by Michael Lewis.

Muni bond market shorts set their 2014 hopes on Puerto Rico, but this month’s successful $3.5 billion bond sale makes the odds of a near term default or restructuring remote. Last year, both major pension systems received major overhauls with many current employees taking reduced benefits. Most of Puerto Rico’s debt is long term and annual deficits are relatively low, so the Commonwealth’s intermediate term financing needs are modest. 

The end of the default “wave” and its limited magnitude leave credit rating agencies in an awkward position. Having repeatedly downgraded government credits, their current ratings are inconsistent with those that prevailed at the beginning of the apparent crisis. Also, their government credit ratings are now even more inconsistent with their ratings for corporate and structured – asset classes that have more underlying risk because issuers cannot levy taxes.

In 2013, Fitch announced that it downgraded twice as many US public finance credits as it upgraded in 2013. Moody’s 2013 transition report has yet to appear, but weekly accounts of its upgrades and downgrades at MunicipalBonds.com suggest a similar pattern. This preponderance of downgrades is occurring despite the overall improvement in state and local government finance. Renewed economic growth is yielding more income and sales tax revenue, rising home prices are swelling property tax receipts and a buoyant stock market is shrinking unfunded pension liabilities. But because Moody’s decided to use a lower rate of return assumption for pension fund assets, it has created the perception of increased credit risk, despite the absence of such. The blizzard of downgrades has largely offset the (upgrading) effects associated with the 2010 reconfiguration of the municipal ratings scale that had been undertaken in the wake of a lawsuit by Connecticut’s attorney general.

Meanwhile, the high profile states of California and Illinois remain at single-A despite the marked improvement in their prospects. Since Moody’s last downgraded California, the state has swung from deficit to surplus and seen a substantial decrease in its unemployment rate. Illinois, downgraded in mid-2013 due to a temporary failure to pass pension reform, has yet to see a compensatory upgrade now that the reform has been enacted. My own view was that neither state had material default risk in the medium term, given their low debt service requirements relative to projected revenue.

Markets appear to be rejecting the drumbeat of dire rating actions. In the same week that Puerto Rico successfully sold its non-investment grade issue, Chicago placed $884 million in securities on the heels of two Moody’s downgrades (a three notch reduction from Aa3 to A3 in July 2013 followed by a further one notch cut to Baa1 this month).

Perhaps markets have started to ignore ratings because they have become so rudderless. Ratings have inconsistent meanings because they are products of human discretion. If, instead, they were the outcome of stable, empirically-based algorithms, ratings would more likely have the same meaning across time and between categories. Unlike human analysts, computer models don’t have to worry about criticism that they are being soft on politicians or inadequately mindful of unfunded pension liabilities – which are rarely associated with actual bond defaults anyway.

Finally, it is worth noting that inconsistent, incoherent ratings are not merely a sin of US rating agencies. Dagong, which commanded respect for issuing a sub-AAA rating to the US back in 2010, has not covered itself in glory since. After the end of the October 2013 government shutdown it inexplicably downgraded the US rating to A-.

The Chinese rating agency, apparently unaware that partial shutdowns are a familiar part of the US political scene, suggested that the October incident reflected an unprecedented level of risk. Contrary to political and media hyperbole, there was never a serious risk of a Treasury default arising from either a shutdown or a delay in raising the debt ceiling. While I agree that an issuer that engages in kabuki theatre over its credit obligations cannot warrant a top rating, it is absurd to place the world’s most powerful government a few notches above junk amidst declining deficits and accelerating economic growth. Further, we should all take pause from the fact that the Fed has proven capable of buying the lion’s share of new Treasury issuance with freshly printed money and without triggering price inflation.

Dagong’s goal appears to be to convince the world that the US is a worse credit than China. That’s a hard case to make given the latter’s relatively short history as a market participant, its lack of transparency and the risk that its single party political system cannot be sustained over the long term.

But regardless of the ratings themselves, Dagong’s process is disturbingly similar to that of the Western incumbents – discretionary ratings subject to political pressure and human biases. This is unfortunate for a rating agency that hopes to displace the ruling ratings triumvirate. By declining to offer a superior analytical product, Dagong leaves investors little choice but to stay with the incumbents.

For Puerto Rico, Low Transparency ==> High Yields

Puerto Rico 10-year bonds have been yielding around 8% in recent weeks. That’s a 400bp premium over bonds over AAA munis and 500bp over Treasuries – for instruments that are triple tax free throughout the US.

Muni market headlines focus on the Commonwealth’s large debt (over 100% by some measures), underfunded pensions and weak economic performance. Yet revenues are rising, the largest pension system has been reformed and the Commonwealth has enough cash on hand to avoid issuing any new GO debt for the remainder of Fiscal 2014.

Perhaps Puerto Rico’s risk is not as great as the 8% bond yields suggest. I say perhaps, because gaps in the Commonwealth’s disclosure make risk assessment and monitoring challenging.

Earlier this year, I built a fiscal model for Illinois that suggested the state’s absolute credit risk was limited. The model estimated the probability that interest and pension costs – two large uncontrollable, senior obligations – would claim 30% of state revenues – a level associated with previous defaults in US states and comparable jurisdictions. The state of Illinois supports modeling of this sort by providing a comprehensive annual financial report, interim financial reporting, a multi-year budget forecast and pension system actuarial reports that forecast contributions, benefit levels and other indicators over the next thirty years.

SPARSE, INCOMPLETE, LATE or OUT of DATE

Puerto Rico provides some of these elements, but many aspects of the Commonwealth’s fiscal disclosure are missing, delayed or incomplete.

For example, the Commonwealth’s 2012 CAFR appeared on September 16, 2013 – more than 14 months after the end of the fiscal year. This is later than every US state, and substantially later than most.

Although it takes time to produce audited financials, unaudited cash statements should be easy to generate shortly after the fiscal year end. Yet, as of early December, a statement of fiscal 2013 full year revenues and expenditures by category was still unavailable (see http://www.bgfpr.com/economy/General-Fund-Net-Revenues.html for where the report is supposed to appear). Since the fiscal year ended on June 30, prospective investors have now been waiting over five months for this statement. The Puerto Rico Treasury Department likely has this data: components have appeared in press releases and Treasury has already published comparable numbers for the first quarter of fiscal 2014.

Another shortcoming is the lack of a multi-year revenue and expenditure forecast. Illinois provides a three year general fund revenue forecast as part of its budget package. I have found no comparable report for Puerto Rico.

Finally, the Commonwealth’s pension reporting is relatively skimpy and has been rendered obsolete by the 2013 reform. There is no document that provides up-to-date forecasts of annual employer contributions, employee contributions, benefit levels, administrative expenses or asset valuations.

Thus, Puerto Rico asks investors to lend it money on a long-term basis but fails to provide them the tools necessary to readily forecast the Commonwealth’s ability to service these debts. The resulting uncertainty may well be feeding the frenzied selling that has recently taken Puerto Rico spreads to astronomical levels.

The current administration has been trying to step up its investor relations. There are investor calls, slide presentations and even a voluminous Commonwealth report. But the volume of interaction is a poor substitute for quality, consistency, and predictability – at least for those in the bond markets.

Rather than providing reams of assertions and stale data, the Commonwealth would do well to provide investors and other stakeholders, concise, timely and complete financial statements and projections. It’s the provision of the expected, necessary, transparency that could yield lower yields.