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CRE Finance World, Winter 2014

too much leverage, combined with interest-only secondary or tertiary market on a non-stabilized property. And it may be a refinance so you have no true value data point or fresh equity. You start combining all that and you see deterioration in credit quality. Some originators are trying to hold the line but you can see how it is becoming harder. Jon Strain: The one thing I would point out is that subordination levels are going up. I take that as an encouraging sign because I think one of the things that was scariest to watch in the first cycle was that rating agency levels converged, despite qualitative differences in pools. I remember being a part of the TOP program and we were selecting out lower LTV loans thinking we would get a better capital structure, and a smaller B-piece and could price tighter. Eventually the larger pools and higher leverage had the same structure and to me it didn’t make sense. What we are seeing now is that rating agencies subordination levels are going up at the BBB level, which is really where they should show up. At the AAA level, there is so much diversity that the AAA investor probably bears less risk on the margin from the additional leverage, but the BBB part of the capital structure or below definitely is seeing some changes and that is having some pricing impact, which should discipline some people. Brian Lancaster: So you’re saying this time around, while we are seeing some deterioration, it seems that the rating agencies are doing their job. Their adjusting and tuning subordination levels and credit enhancement upward. Jon Strain: Yeah, John, you’re seeing that too, right? John Mulligan: Yes, it’s not just in BBB either. Over the course of the year, you see it in AAAs. You’ve seen a move from the lows to highs of five points in the natural AAA sub-level, so it’s up and down the curve. I’d also say that the investors seem to be pricing deals differently too. Going back to the credit quality question, I’d say that it’s certainly not 2010, but it’s not a one way train south across all of the credit metrics, they bump around from deal to deal if you look at them in the aggregate. The rating agencies and the investors seem to be rewarding pools with better credit quality. Randy Wolpert: And I think that makes sense on the investment grade bonds but when you are buying the bottom like we do, it doesn’t really matter because we are only as good as our worst loan. So if you have a couple of loans that we think could have high loss severity , it doesn’t really matter how the deal is rated because those loans could impact our returns too drastically to invest in that deal. CRE Finance World Winter 2014 16 Brian Lancaster: Over the last six months we haven’t seen Moody’s much at the bottom of deals. In this discussion we seem to be saying that the rating agencies are sufficiently adjusting enhancement levels to compensate for lower credit quality. What is your take on Moody’s? Apparently they beg to differ. Are they a crazy outlier? Jon Strain: Rating agency models are all different and produce different answers at the bottom. So when you have three rating agencies and you are trying to get them all lined up nice and neat, there are differences. The B-piece is placed up front and we sell a specific size, call it 7.5%, at a fixed yield of say, 17%. The B-piece buyers are bidding broker dealers for a specific size of the investment and not to specific agencies ratings. So we don’t really need a specific rating agency such as Moody’s. The BBB- enhancement is basically where the size of the B-piece is decided and most B-piece bids only require 2 agencies. So in some instances Moody’s Baa3 level has been higher than the so called “B-piece stip”. Also, the BBB investors don’t want a third rating if it will be lower than an investment grade level. Some other rating models have been even more conservative than Moodys at the BBB- level and so you may not see certain combinations but when you’re an issuer; there are six agencies that you can use. Moody’s is one of the largest and certainly one of the more respected ones, but I think the investor focus on “who” has diminished. You’ve seen Morningstar launch their platform, and now Kroll, who was really the last into the business. It has come a long way with a very experienced staff that they have hired largely from other rating agencies. They have been much more successful than people thought they would be. Brian Lancaster: John, recently Goldman Sachs pulled from a $1.1 billion CMBS deal, a $47.5 million Jefferies loan linked to 10 shopping malls in Nebraska and South Dakota, the Perkins Retail Portfolio, because of a potential dispute between the borrower and the lender. I believe this was the first time a loan was pulled out of a deal after pricing. The deal had already priced at a significant concession to another deal priced that same day so it seemed investors were already concerned about credit quality. How did you see this incident? Is this positive showing investors won’t put up with poor loans in deals or a bad sign of originator overreach? John Mulligan: I took it as a positive. You have to break down the timing of the events. I believe information came out even as the deal was pricing with regard to the prior servicer wanting to re- engage with that borrower. I assume that the prior servicer wants to understand how the appraisal jumped so dramatically and whether or not the borrower had tenants in his back pocket during the DPO negotiation. The facts around that are not clear to me. CRE Finance World Roundtable Discussion: 2014 Outlook


CRE Finance World, Winter 2014
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