Issuers in Europe are increasingly turning to unrated CMBS. Since August 2012, 10 unrated deals totalling approximately €2.2 billion ($2.45 billion) have been completed, making it a new asset class.
Why the shift toward unrated bonds, especially since unrated CMBS prices more expensively? Despite the disadvantages, issuing CMBS on an unrated basis can save considerable costs for arrangers particularly in relation to hedging and liquidity facilities. Some regulated investors may, for the time being, receive more favourable regulatory capital treatment for investments in certain types of unrated CMBS.
It’s not entirely clear how the European CMBS market will shake out on the question. The markets are continuing to explore the potential of unrated CMBS. These transactions may, for example, lead to the development of the first true private placement market for CMBS in Europe. However the market develops, it seems that this new type of CMBS will have a role and will continue to be seen in some volumes in Europe.
Rationale for Issuing Unrated
There is no single reason why these unrated transactions were issued. However, some general themes appear to be common to many of the issuances which may provide guidance as to when and where unrated CMBS will be issued in the future:
- Transactions, such as DECO 2013-CSPK, involved smaller property portfolios than typical CMBS transactions;
- Smaller transactions which do not require wide marketing (e.g. Mint Mezzanine and Midas) and can be privately placed;
- Transactions that could have been syndicated as loans, but investors preferred bonds (e.g., Mint Mezzanine, Midas, Zephyrus and Reni). These are simple “pass-throughs” of the underlying loans without any structural or credit enhancements and were arranged for particular investors seeking exposure to the underlying loans through fixed income instruments, such as CMBS bonds.
- One transaction (Utrecht) was arranged to permit existing investors to retain an interest in a refinancing. Investors did not appear to require ratings. This was unusual but may be more common as legacy CMBS winds down in the coming years with small but troubled asset pools.
Advantages of Issuing Unrated
The overriding reason to issue unrated CMBS is cost. Rating agencies will charge an upfront fee and an annual surveillance fee to rate a transaction. Complying with rating criteria on an on-going basis will also involve costs. Finally, new regulation imposes further costs on rated securitisations.
- Significantly fewer institutions now retain the high credit ratings needed for liquidity facilities, hedging and bank accounts for AAA/Aaa rated securitisations. Those institutions that do not have such credit ratings face a significantly more onerous regulatory burden when they provide such arrangements through measures such as the European Market Infrastructure Regulations (“EMIR”) and the imposition of significantly higher regulatory capital costs for providing liquidity facilities under Basle III. This has caused some institutions to withdraw from the market entirely and the remainder to pass on their increased costs to the securitisations.
The cost of arranging liquidity facilities for AAA/Aaa rated CMBS has changed as follows:
|Pre-Credit Crunch||Post-Credit Crunch|
|Commitment Fee||0.20% – 0.25%||1.0%|
|Drawn Margin||0.35% – 0.50%||2.0% -2.5%|
As such, undrawn, post-credit crunch liquidity facilities are between 4-5 times as expensive as undrawn, pre-credit crunch facilities and more than twice as expensive when drawn.
Ratings criteria for AAA/Aaa CMBS require key transaction parties to agree to specific provisions in relation to their credit ratings. For example, hedge counterparties must provide collateral on their downgrades below specified levels. Therefore, hedging that is not rating compliant is generally less costly than hedging for rated CMBS.
Similar issues exist for liquidity facilities. Some unrated transactions have been issued without liquidity facilities, using expense reserves to cover unpaid costs arising through non-payment on the underlying CRE loans. The lack of liquidity facilities adds significant stress to the rating for any CMBS other than for transactions secured by very granular pools of properties. Significant costs can be saved on a CMBS if no liquidity facility is required.
- Unrated CMBS transactions may (depending on their structures) be exempt from particular regulations and hence save compliance costs. Other forms of unrated CMBS may offer regulatory advantages to particular types of investors.
Rule 17g-5 of the US Securities Exchange Act requires rated transactions offered to U.S. investors to maintain electronic archives of information provided to the rating agencies rating the transaction. This information must be available to other rating agencies to permit them to issue unsolicited ratings. Compliance with this rule adds costs for rated transactions.
Further European regulation applies to transactions treated as “securitisations” under the Capital Requirements Regulation (“CRR”). This defines securitisations as transactions tranching an “exposure” or pool of “exposures” (for CMBS, CRE loans) where the subordination of tranches determines the distribution of losses during the ongoing life of the transaction. In other words, a “securitisation” is a transaction where multiple classes of bonds are issued on a senior-subordinated basis.
Under the Regulation for Credit Rating Agencies (“CRA III”), if a structured finance transaction is rated, it must be rated by at least two credit rating agencies. Obviously, such requirement will add costs to a securitisation.
The regulatory capital treatment for regulated investors holding unrated, untranched CMBS is unclear. As such transactions are not tranched, they may not be “securitisations” under Basel III and Solvency II rules. As such, there seems to be no guidance as to the regulatory capital treatment of such transactions.
Commentators suggest that regulated investors in unrated, untranched CMBS applying the Internal Ratings Based (“IRB”) Approach may “look through” the structure and treat CMBS as a direct investment in the underlying CRE loan. This applies only to “pass through” CMBS backed by a single CRE loan with no credit enhancements as otherwise, the CMBS bonds would not be effectively the same as the CRE loan. Depending on the terms of the underlying CRE loan, particularly its loan to value (LTV), this could result in regulated investors achieving favourable regulatory capital treatment.
Some unrated European CMBS transactions involved the issue of single tranches of bonds; Reni SPV, Pangaea Funding, Mint Mezzanine and Midas Funding. Reports suggest that the more favourable regulatory treatment of unrated, untranched CMBS may have motivated these transactions.
For unrated, untranched CMBS to receive favourable regulatory capital treatment would be inconsistent with other forms of CMBS. It would also be illogical for the senior tranche of an unrated, tranched CMBS to be treated less favourably than an unrated, untranched transaction and as such, specific guidance may well be issued to address this.
CMBS transactions are arranged to generate profits for the arranger through the differential between capital markets pricing and loan market pricing (conduit deals) or, to access efficient capital markets funding for the related borrower (agency transactions). In either case, the market pricing for the CMBS and its start-up and on-going costs will affect the viability of the transaction. This is particularly important for conduit CMBS where profit extraction is sensitive to bond pricing and to recurring costs such as liquidity facility and hedging costs.
Disadvantages of Issuing Unrated
Credit ratings provide assessments of the likelihood of payments being made in full and on time. A wider range of investors will be more interested in rated than unrated investments. This is even more pronounced with complex assets such as CMBS where an investor would need considerable resources and expertise to undertake the level of analysis equivalent to that provided by a credit rating. Certain investors (particularly funds) are also constitutionally restricted from making unrated investments. Due to this, unrated investments are less liquid than rated ones leading investors to seek higher returns.
Recent regulatory changes have further reduced the liquidity of unrated investments (particularly unrated tranched securitisations including CMBS) by imposing punitive capital treatment for regulated investors under Basle III.
In Europe, the Capital Requirements Directive (enacting Basle III) provides for different treatment for regulated investors holding unrated tranched CMBS depending on whether it is permitted to use the Standardised Approach or the IRB.
Investments in unrated, tranched securitised bonds will, generally under the Standardised Approach, either carry risk weightings of 1250 percent or require the investor to make a full deduction from capital for their investment. Investors using IRB apply the “supervisory formula approach” using a complex formula based on the structure of the investment and the nature of the underlying assets to calculate the capital requirements. A full analysis of this is beyond the scope of this article but it is understood to be very unfavourable.
Regulated investors holding unrated tranched CMBS bonds, will generally not be able to finance their investment through the ECB’s Long Term Refinancing Operation or the Bank of England’s Asset Purchase Facility as these schemes require investments to be rated.
With relatively few transactions completing recently, useful direct comparisons between rated and unrated CMBS are rare. Two specific examples are:
|September 2013||Monnet Finance||German multi-family||Class A
4.96% (fixed rate)
|October 2013||German Residential Funding 2013-2||German multi-family||Class A
6.50% (fixed rate)
|December 2013||Gallerie 2013||Italian retail||Class A
|January 2014||Reni SPV||Italian retail||Single class||€135.0||Unrated||5.162%|
It can be seen from the previous table that unrated CMBS prices are at considerably higher levels than equivalent rated transactions. This differential will vary with a wide range of loan and market related factors and, depending on the size of this differential, arrangers will have to weigh this against the cost savings of issuing unrated.
A Halfway House?
The expense and scarcity of providers of liquidity facility, hedges and bank accounts for AAA/Aaa rated transactions has led to some recent transactions issuing with maximum ratings of A/A2. Rating criteria for A/A2 rated CMBS is more relaxed and generally liquidity facilities are not required. Recent examples include Debussy, Taurus CMBS UK 2014-1 and AYR Issuer S.A. These transactions can be seen as compromise structures, avoiding the most onerous ratings requirements but not suffering all of the pricing disadvantages of issuing unrated (as described above) while avoiding the most punitive regulatory capital treatment for unrated tranched transactions.
A recent example of this is Antares 2015-1, which is currently being marketed. Commentators have suggested that adding a liquidity facility to the structure would increase transaction costs by approximately 0.10 percent but this would allow the bonds to achieve a AAA/Aaa rating which would decrease pricing on the bonds by approximately 0.14 percent.
Privately Placed CMBS
The emergence of unrated CMBS gives rise to the question of whether a true private placement market can be developed for European CMBS. Arrangers could save considerable costs if investors did not rely on arrangers for disclosure but instead carried out their own due diligence.
European CMBS is generally listed because: (a) investors prefer the added liquidity of listed bonds and (b) listed bonds qualify for the “quoted Eurobonds” from withholding taxes. However, most stock exchanges permit securities to trade on either a regulated market or an unregulated market, with lower disclosure requirements applying to the unregulated market provided that the offering meets the exemptions for disclosure required under the Prospectus Directive. Some recent European CMBS transactions trade on unregulated markets (e.g. Mint Mezzanine 2014). However, the offering circulars for these deals are as detailed as those used for transactions trading on the main regulated markets demonstrating a reluctance to reduce the disclosure even for privately placed transactions.
There is no particular reason why CMBS trading on the unregulated market of a stock exchange could not be issued with short and simple offering circulars with investors undertaking their own due diligence. However, this has not yet been seen in the market and there seems to be no consensus as to whether this would be acceptable to investors.
European CMBS is set for its best year since 2007. €3.3 billion of new CMBS has been issued in Europe in the first half of 2015 compared with €887 million in the first half of 2014. It is also clear that new pressures from regulators and market sources are driving the development of new forms of CMBS.
The development of products such as unrated CMBS and A/A2 CMBS shows that CMBS can continue to innovate and find solutions to the challenges it faces. As such, the future of CMBS in Europe seems more secure today than has been the case for a number of years.
Publicly Announced European Unrated CMBS
|August 2012||Utrecht Funding 1||£215||Dutch offices||Eurohypo|
|June 2013||DECO 2013 – CSPK||£380||UK offices||Deutsche Bank|
|September 2013||Monnet Finance||€406||German multi-family||Deutsche Bank|
|January 2014||Reni SPV||€135||Italian retail||BNP Paribas|
|August 2014||Taurus 2014 FR-1||€410||French offices||Merrill Lynch|
|August 2014||Pangaea Funding 1||€237||Greek offices||Cairn Capital|
|December 2014||Zephyrus (ELOC 30)||£196||UK retail||Morgan Stanley|
|February 2015||Mint Mezzanine 2014||£75.9 & €30.9||UK hotels||J.P. Morgan|
|April 2015||Midas Funding UK||£100||UK offices||Morgan Stanley|
|July 2015||Lusso S.r.l.||€75||Italian retail||BNP Paribas|
 Bank of America Merrill Lynch – European SF & CB Weekly, 1 June 2015.
 Bank of America Merrill Lynch – European SF & CB Weekly, 18 May 2015.
 Bank of America Merrill Lynch – European SF & CB Weekly, 8 June 2015.
 European Regulation (EU) 648/2012, 4 July 2012
 European Regulation (EU) No 575/2013, 26 June 2013.
 Many pre-credit crunch CMBS did not provide this information.
 In a small number of transactions fees and margins were higher or lower than shown here.
 European Regulation (EU) 575/2013.
 Article 4 Clause (61) of Article 4(1) of European Regulation (EU) 575/2013. Under CRR, a tranche can be a class of bonds or a loan.
 European Regulation (EU) No 462/2013, amending Regulation (EC) No 1060/2009.
 Real Estate Capital, Quasi-CMBS issues sound a new property debt note, June 2015.
 Zephyrus (ELOC 30) issued one class of bonds and a subordinated loan which is treated as a tranche under the CRR.
 Real Estate Capital, Quasi-CMBS issues sound a new property debt note, June 2015.
 Subject to limited exemptions for the most senior tranches of bonds issued.
 In transactions where the composition of the pool of securitised assets is known at all times, as an alternative, investors may look through to the risk weighting of the pool and apply a weighted average risk weight by multiplying the risk weight of the underlying assets by a concentration ratio equal to the nominal amount of all tranches in the structure divided by the nominal amount of all tranches junior to or pari passu with the tranche in which the firm has a holding. However, as CRE loans are themselves 100% risk weighted, this is unlikely to produce a better result.
 These schemes are dynamic and flexible and have on occasion relaxed their criteria (including ratings requirements) for particular types of investments and particular jurisdictions to meet market needs.
 A two tranche £171.1 million UK office CMBS rated A/BBB- arranged by RBS.
 Bank of America Merrill Lynch – European SF & CB Weekly, 1 May 2015.
 For the purposes of the Markets in Financial Instruments Directive 2004/39/EC (MiFID).
 European Directive 2003/71/EC.
 The Mint Mezzanine offering circular runs to 366 pages.