The key pillars of loan quality are eroding, a Moody’s report notes, providing fewer protections for investors. The weakening of credit quality comes as malls serving economically depressed areas are closing at a rapid rate, with mall delinquency rates rising, just as the credit quality of the repackaged loan investment products, particularly commercial mortgage-backed securities (CMBS), is called into question. The center of the problem resides in single-borrower deals, but a panoply of five weakened protections are credit negative, placing the “mortgage lender in a weaker credit position.”
CMBS loans being weakened by eroding "bad boy guarantees"
Deep inside the loan quality characteristics of CMBS products are a host of weakening credit criteria making the collateralized loan securities riskier.
This includes in some cases missing, non-recourse carveouts colloquially known as “bad-boy guarantees.”
“Recourse liability provisions are designed to strongly incentivize the borrower to adhere to the terms of the loan documents,” Moody’s analyst Daniel Rubock and his structured finance team wrote in a note titled “Key pillars of loan structural quality are eroding, especially in single-borrower deals.”
He notes that if such provisions are not precise or “inadequately punitive, or if the bad-boy guaranty is absent or limited to significantly less than the full amount of the loan,” the threat of recourse used to encourage repayment is diminished. “Borrower activities that transaction documents once strictly forbade become simply part of a cost-benefit analysis that a borrower can consider when times get tough.”
Moodys observes a growing number of transactions using a “hard cap” of 10% to 20% of the loan amount on the sponsor’s recourse liability for losses and full recourse. The trend began in 2012, but recently gained steam.
“We generally view caps on guarantor liability as credit negative, because such caps can dramatically lessen the economic disincentives affecting the guarantor, allowing it to countenance the bad acts of the subsidiary borrower it controls,” the report said, also pointing to an erosion of the absolute dollar amount of net worth covenants. “We view inadequate net worth covenants as credit negative, particularly in situations in which an entity rather than a person (a “warm body”) is the guarantor, as that entity could divest itself of assets, transforming itself into a mere shell.”
CMBS troubles: Lower quality malls in economically depressed areas most at risk
Transferring ownership of assets can be a very real concern that extends to businesses that are failing.
Moody’s uses the example of a property owned by multi-billion dollar retail-focused REIT with scores of super-regional malls under its investment product umbrella. Under a “qualified transferee provision,” the borrower may transfer ownership to a “sponsor that has total assets of $750 million and a net worth of $300 million, and owns five regional (not super-regional) malls,” the report noted. “The potential for a transfer to such a less-experienced, deep-pocketed sponsor would need to be reflected in the credit analysis.”
The issue was in the news most recently, as Sears plans to close 150 stores and Macy’s is slated to close 100, moves that impact mall-backed CMBS.
Since 2010, liquidations of nearly $3.89B led to $2.88B in CMBS losses, a 74% loss severity, according to Morningstar data reported by BISNOW.
Morningstar forecasts nearly $1.88 billion in losses on 53 specially serviced mall-backed loans with an unpaid principal balance of $3.4 billion, pointing to a 55.3% loss severity. The majority of the troubled malls are in lesser quality Class-B or C malls in lower demographic areas struggling economically.
The list of five primary “erosion” problems cited in the Moody’s report are: 1) diluted, or in some cases completely absent, non-recourse carveout (‘bad-boy”) guarantees; (2) annual audited borrower financial statements that are either unavailable, or are available too late; (3) meager property release provisions; (4) low-threshold qualified transferee provisions; and (5) low cash sweep triggers.
“When solidly constructed, each of these five pillars of loan credit quality offers significant protection to the mortgage lender,” some of which appear to be disappearing.