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Approach to Rating
Floating Rate Transactions
John Junyu Chen and Commercial mortgage-backed securities MARKET DRIVERS
Milton Chacon (CMBS) collateralized by floating rate loans The CMBS market currently offers commer-
(floaters) have become an important part of cial real estate borrowers two primary
the CMBS market. Because they typically financing alternatives: long-term fixed-rate
have low prepayment penalties and short and short-term floating rate loans.2 Long-term
lock-out periods, floaters have generally fixed-rate loans typically have ten-year terms,
appealed to borrowers with transitional assets 20-year to 30-year amortization schedules
or short-term holding horizons. However, and strong call protection.3 This level of
based on their interest rate expectations, prepayment protection provides investors
some conduit borrowers may opt for floaters more certainty in cash flows and has helped
as a flexible financing alternative that will make the current CMBS interest only (IO)
provide them with the opportunity to refi- market viable.
Chen
nance in a more favorable interest rate
environment. Long-term fixed-rate financing typically suits
the needs of long-term borrowers with stabi-
Moody’s approach to rating floating rate lized assets. On the other hand, floating rate
CMBS transactions shares the same method- financing is more attractive to borrowers that
ology as that used for fixed-rate CMBS, except require prepayment and refinancing flexi-
for an additional step necessary to assess the bility due to the transitional nature of the real
credit risk associated with floating interest rates. estate asset or the borrower’s expected short
First, Moody’s reviews the collateral perfor- holding period. In addition, traditional
mance and determines stabilized cash flows. conduit borrowers with stabilized assets may
A fixed-rate-based baseline credit enhance- also consider floating rate loans. These
ment is derived using Moody’s debt service borrowers anticipate that interest rates will
Chacon coverage ratio (DSCR), loan to value (LTV) decline at some point over the next few years,
ratio and asset quality grade. In the next step, at which time they will prepay their loans
interest rates are stressed to determine the and lock in more favorable fixed-rate
credit enhancement adjustment necessary to financing.4
compensate for floating rate risk. This adjust-
ment incorporates the impacts of both A CMBS floating rate loan typically has a
potentially higher interest advancing costs two-year to five-year term and provides for a
and additional term defaults associated with one-year or two-year contractual extension.
the interest payment volatility.1 The default The prepayment penalties are less onerous
frequency at balloon is the same for both than their fixed-rate counterpart and may
fixed-rate and floating rate CMBS. This include a short lock-out period followed by a
adjustment is further calibrated to reflect the stepping down percentage penalty, as
joint probability of simultaneous interest rate opposed to the potentially very expensive
and real estate stresses. As in the fixed-rate prepayment costs associated with yield main-
CMBS rating methodology, the final step tenance and defeasance. Floaters are often
consists of portfolio adjustments for elements interest only loans, so the initial coverage is
such as diversity, structural characteristics and typically higher than for equivalent amor-
quality of underwriting. tizing fixed-rate loans.
summer 2000 7
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
The Impact of Floating Interest Rate on default frequency because rising interest rates may
Expected Loss cause additional defaults during the loan term due to
Moody’s analysis of the credit impact of floating rate the mismatch between stable property cash flows and
loans is based on the expected loss concept, which incor- rising debt service.11 The probability of floating rate-
porates both default frequency and loss severity. The induced additional term defaults depends on the
frequency of default during the loan term is generally stressed interest rate as well as the capacity of the
determined by the borrower’s ability to make debt property’s cash flow to absorb rising debt service.
service payments based on the property’s cash flow. Such capacity is reflected in the loan’s break-even
Either a decline in property cash flow or an increase in interest rate.12
debt service can increase term default frequency. Balloon • Loss Severity: For loans that would have defaulted
default frequency depends on the interest rate environ- under the related fixed-rate stress scenario, the
ment and balloon balance at the time the loan matures. severity of loss associated with property value losses
If the balloon balances are the same, both floating and and workout costs for these defaults are assumed to be
fixed-rate loans bear the same refinancing risk. unaffected by the floating rate. However, interest
The loss severity represents realized losses on a CMBS advancing costs will be higher if interest rates rise
collateral pool, and servicer advancing of default interest during the related workout period when a floating rate
is assumed. Therefore, the loss severity has three major loan defaults, as the advancing rate is based on the
components: property value losses, workout costs, and then current interest rate. In contrast, after a fixed-rate
advancing costs. Property value losses result from loan defaults, the servicer is required to advance
declines in the property values below the outstanding interest payments at the stated fixed-rate to the
loan amounts, due to either reduced cash flows or rising CMBS certificate holders. The additional advancing
capitalization rates. Workout costs include special costs, if any, are deducted from the final liquidation
servicing fees, legal costs and other third party fees. proceeds, resulting in a higher loss severity in the
Advancing costs result from the servicer’s obligation to event of default. For loans that default during the term
advance unpaid debt service on defaulted loans.10 Upon due to the floating rate feature, i.e. potentially higher
final disposition of the defaulted asset, the servicer is interest payments, the loss severity is expected to be
reimbursed all advanced debt service and interest lower than defaults caused by changes in real estate
thereon, before any principal distributions are made to values. The losses on additional term defaults caused
the certificate holders. Higher interest advances hence by interest rate volatility come primarily from
result in higher realized losses to the trust. workout and advancing costs.
summer 2000 9
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
market downturn. Moody’s believes that the floating rate The following is a step by step explanation of the proce-
adjustment should not be a pure addition to the baseline dure for calculating the floating rate credit enhancement
credit enhancement, therefore a joint probability factor adjustment for a loan with a Moody’s LTV of 85%, as
is applied to the floating rate adjustment to reflect the shown in Chart 3. The same procedure applies to the
possibility of both real estate and interest rate stress not other two loans as well. The loan is assumed to have a
occurring during the same period.13 three-year term plus a one-year extension, a spread of 2%
over LIBOR, and no interest rate cap. For this example,
CALCULATING THE FLOATING RATE the stressed interest rate for the Aa2 rating level is
CREDIT ENHANCEMENT ADJUSTMENT 14.25%, the sum of the stressed LIBOR of 12.25% and
Moody’s has developed a CMBS floating rate approach the spread of 2%. The breakeven interest rate is calcu-
to quantify the credit enhancement adjustment neces- lated by dividing the property’s net cash flow by the loan
sary to compensate for the floating rate risk. The amount. There are four steps involved in the calculation
approach incorporates loan specific inputs such as term of floating rate credit enhancement adjustment:
to maturity, terms of borrower extension options, DSCR • Step 1: Evaluate baseline default frequency. Using
and LTV ratios, spread over LIBOR and the strike rate of Moody’s fixed-rate rating methodology, assume that 22
the interest rate cap if one exists. This loan specific infor- points of credit enhancement are deemed necessary for
mation, together with the stressed interest rate an Aa2 rating, prior to considering floating rate risk.
assumptions discussed above, is used to calculate an This credit enhancement considers a 55% default
adjustment for each rated class of securities. frequency and a 40% loss severity.
To illustrate our approach, we have selected three • Step 2: Calculate additional loss severity. For the base-
sample floating rate loans representing different levels of line default frequency (55%), additional loss severity
leverage with Moody’s LTVs of 65%, 85% and 95%. occurring due to increased interest advancing costs
Chart 3 presents the calculation of floating rate credit needs to be determined. The additional advancing rate
enhancement adjustments for these three loans. In this per year is calculated as the difference between
example, the calculation is focused on the Aa2 class, Moody’s hurdle rate of 9.25% and the Aa2 stressed
however the same methodology applies to other rated interest rate of 14.25%, or 5%. Allowing for an average
tranches by varying the levels of interest rate stress workout period of 1.5 years, the total additional
together with incremental default frequencies and addi- advancing costs would represent an incremental loss in
tional advancing costs. the event of default of 7.5% (1.5 years x 5%). The
10 CMBSWORLD
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
product of 7.5% (additional advancing costs) and the • The floating rate credit enhancement adjustment is
55% (baseline default frequency for Aa2) results in higher for loans with longer terms to maturity, inclu-
approximately 4.1 points of additional credit loss at sive of contractual extensions. All contractual
the Aa2 rating. extensions are assumed to be exercised in our analysis.
• Step 3: Estimate additional term defaults. As a result of Higher interest rate assumptions are used for longer-
interest rate stress for an Aa2 rating, an additional term term loans to reflect the increased uncertainty about
default frequency of 22% is estimated based on the interest rate levels over a longer horizon.
likelihood of the breakeven mortgage rate being lower • Floating rate loans are often interest only. Additional
than the stressed interest rate, bringing the total default credit enhancement may be necessary due to the lack
frequency to 77% (55% + 22%). This estimate of loan amortization, in addition to the floating rate
considers the option value for borrowers not to default credit enhancement adjustments.
immediately when the stressed interest rate exceeds
the breakeven rate, as well as the probability distribu- INTEREST RATE CAPS
tion of future property cash flows. The loss severity for The above example illustrates the floating rate credit
the additional term defaults is primarily due to enhancement adjustment with no interest rate caps.
workout and interest advancing costs, estimated at Often, borrowers are required by lenders to purchase
20%. Therefore, the additional credit loss from addi- interest rate caps to mitigate rate volatility during the
tional term defaults is 4.4 points (22% x 20%).14 loan term. An interest rate cap has two primary credit
• Step 4: Determine floating rate credit enhancement benefits: (1) reducing the additional default frequency
adjustment. Based on step 2 and step 3, the aggregate during the term, and (2) reducing the interest payment
credit loss is 8.5%. (4.1% + 4.4%). However, the shortfall, until the cap expires, for loans that do default
chance of an extreme interest rate environment and a during the term. Moody’s prefers that the cap issuer be
severe real estate recession occurring simultaneously is rated at least Aa2 to receive the full benefit for the
not very high. Therefore at an Aa2 rating level, a 65% interest rate cap.
joint stress probability is applied to the floating rate-
Timing of Defaults
related credit loss of 8.5%, resulting in the final floating
rate credit enhancement adjustment of 5.5 points To determine the benefit of a cap, it is necessary to
(65% x 8.5%). consider the timing of defaults. Lower leverage loans will
generally take longer to default since the likelihood of
Chart 3 also presents the calculation for the other two
short-term credit deterioration is lower, and shorter term
loans with low and high leverage. The floating rate
loans will tend to have more defaults closer to the
adjustment is lower for the low leverage loan (2.9%) and
balloon date. Chart 4 presents an illustration for a loan
higher for the high leverage loan (6.0%). Note that the
with a 3-year term. Assume that an all-in interest rate
additional term default frequency for the high leverage
cap with a strike rate of 9.25% is purchased for the loan
loan is capped at 10% because the baseline stressed
term, and that on average it will take 18 months to work
default frequency is already 90%.
out a defaulted loan. Should interest rates rise shortly
In general, the floating rate credit enhancement adjust- after the loan is originated, and the all-in rate for the
ments have the following characteristics: sample loan becomes higher than 9.25% for the next five
• The floating rate credit enhancement adjustment years, there are three possible scenarios for the timing of
increases with leverage, everything else being equal. For default and the related advancing costs.
example, an investment grade loan may have a floating • Scenario 1: The loan defaults at the end of the first
rate adjustment that is only half of the adjustment year and is being worked out while the cap is still in
required for a loan with conduit-type leverage. This effect. The loan experiences no advancing costs in
difference in the penalty reflects the capacity of the excess of the 9.25% hurdle rate, because the interest
investment grade loan to absorb higher interest rate rate cap effectively removed all incremental
increases during the term without causing a loan default. advancing costs due to interest rate increase. As a
• The floating rate penalty levels off at a Moody’s result, like a fixed-rate loan, there is no incremental
leverage of 95% to 100%. At the high rating levels, loss exposure for this loan.
most of the highly leveraged loans in the pool are • Scenario 2: The loan defaults at the end of the second
already assumed to default even under our fixed-rate year of the term. The cap prevents incremental
stress scenarios, therefore the floating rate penalty advancing costs during the third year of the loan term
consists mostly of the increased advancing costs when the loan is being worked out. However, during
resulting from stressed interest rate scenarios. the last six months of the workout period the servicer
summer 2000 11
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
summer 2000 13