Focus: Failed sale, appraisal delays behind first loss on a AAA bond since 2008 crisis

Vornado Realty Trust

27/08/2024 11:00

* 
      Delayed ratings cut blindsided investors in safest tranche
of
CMBS
    

        * 
      Failed property sale and delayed appraisals led to overly
optimistic valuations
    

        * 
      Critics worry about timely downgrades for other bonds in
similar
positions
    

  
    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. 
    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  PNC.N , 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)
((mailto:Shankar.Ramakrishnan@thomsonreuters.com; +1
2017590156;))