Failed sale, appraisal delays behind first loss on a AAA bond since 2008
crisis
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[August 27, 2024] By
Shankar Ramakrishnan
August 27 (Reuters) - A failed attempt to sell a New York City office
tower helped cause more than a year-long delay for two credit rating
agencies to downgrade a commercial mortgage bond to junk, according to a
source familiar with the situation and a review of filings from the
agencies.
The delayed ratings cut of 1740 Broadway bonds blindsided investors in
the safest tranche of the commercial mortgage-backed securities (CMBS).
The 26% loss on their $157.5 million investment sent shockwaves across
financial markets that rely heavily on ratings as an assessment of
credit quality, and marked the first loss on a AAA-rated bond since the
2008 financial crisis.
Credit rating agencies S&P and DBRS Morningstar downgraded the top-rated
AAA tranche of a commercial mortgage-backed security (CMBS) on 1740
Broadway to below investment grade in August and November 2023,
respectively.
But it was March of 2022, at least 17 months earlier, when private
equity firm Blackstone Group, the owner of the building, turned the keys
over to investors after the anchor tenant decided to move out in the
aftermath of COVID-19, according to the agency reports.
While the loss on the CMBS is known, the Reuters review of the agency
reports and interviews with a half dozen mortgage experts, including a
person who was involved in the situation, for the first time piece
together the sequence of events that led to the delay in ratings
downgrades.
They show that a failed attempt to sell the property in late 2022 and
delayed property appraisals led to the overly optimistic view for months
of how much money the building could fetch to repay investors.
S&P and DBRS told Reuters they shared the rationale behind their actions
on 1740 Broadway and its ratings criteria and methodology, as well as
research that highlighted the challenges in the office sub-sector,
including price discovery, through published reports. They had no
additional comments.
A Blackstone spokesperson said the investment firm "worked with relevant
parties to reach a resolution."
Credit ratings are used across the financial system to assess the risk
of defaults, helping financial institutions and investors determine how
much capital they need to keep on hand to absorb any losses. Many more
bonds worth billions of dollars are in a similar position, and critics
said the failure to downgrade in a timely manner is worrying.
"Investor losses in 1740 Broadway, even at the AAA tranche, call to mind
the ugly specter of 2007's housing crisis and the ratings agencies'
participation in that horrific destruction of wealth," said Paul
Feinstein, CEO of Audent Global Asset Management, which invests in real
estate.
SPECIAL SERVICER
Blackstone bought 1740 Broadway in 2014 for $605 million. The debt that
financed the purchase was packaged into the CMBS the following year. The
building’s main tenant was L Brands, which at the time was the owner of
Victoria’s Secret and other brands.
S&P and DBRS rated the top tranche of the security – the first to be
paid interest from the building’s income – as AAA. At the time of the
CMBS issuance, DBRS noted in its rating report an issue with how cash
from the L-Brands lease was not being saved for a rainy day. But it took
into account "strong sponsorship in Blackstone" as a mitigating factor.
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Rain clouds cover the skyline of Manhattan. May 27, 2022.
REUTERS/Eduardo Munoz/File Photo
Trouble started when L Brands said they would move out in March
2022, prompting Blackstone to default on the loan.
In a commercial backed mortgage security, distressed properties are
turned over to a special servicer, an agent for investors in the
bond who must then resolve the property, usually by selling it.
Soon after Green Loan Services was appointed as the special servicer
in April 2022, it identified a buyer that was offering the full
value of the property, something that would have paid back all the
bond investors, according to the source familiar with the matter.
Over the ensuing months, the discussions between the special
servicer and the potential buyer, previously unreported, got
advanced enough for them to start drawing paperwork for the sale,
the source said.
But around the same time, the Federal Reserve was raising interest
rates to tackle runaway inflation as the country emerged from the
pandemic, hurting property values.
More than seven months later, in December 2022, the buyer eventually
balked and the deal fell apart, the source said.
The lengthy sales talks meant that an independent appraisal for the
building was never ordered, ratings agency reports show. An
appraisal would have revealed the market value of the property at
the time and if it was sufficient to pay down bondholders.
Absent that, agencies relied on their models, which projected the
value to be more than it was worth. In an April 2022 review, for
example, S&P estimated the property was worth $270.4 million, giving
it comfort to keep the rating intact.
LOW APPRAISAL
The appraisal was expected to be ordered, according to S&P, in the
second quarter of 2023. In late February 2023, Green Loan was
replaced by Midland Loan Services, a unit of PNC, as the special
servicer.
The switch put the appraisal on hold again, S&P said in a March 2023
report.
DBRS, too, said Midland reported ongoing discussions "to determine
the appropriate disposition strategy."
Midland and PNC did not respond to requests for comment.
An appraisal was finally provided in July 2023, according to a DBRS
report. It valued the building at just $175 million, which meant
there was not enough money to pay what AAA holders were owed.
S&P cut its rating on the bonds to BB+, which is below investment
grade. The AAA bonds, which were until then hovering around 90 cents
to the dollar, declined to 75 cents and then to 60 cents, said Jeff
Berenbaum, head of CMBS strategy at Citigroup.
(Reporting by Shankar Ramakrishnan; Editing by Paritosh Bansal and
Edward Tobin)
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