Recent years have seen the emergence of a new, unrated form of CMBS in Europe. This has been a uniquely European phenomenon. US CMBS is invariably issued with credit ratings, although unlike European CMBS, US CMBS is commonly issued with below investment grade rated tranches of bonds and which, in the past, has also gone down to unrated classes of bonds. With nine unrated deals having completed to date in Europe, including deals from the most prominent issuing banks, it would seem that a new asset class has been developed.

This article considers how this has arisen, the reasons for issuing on an unrated basis (as well as the disadvantages of doing so) and the prospects for such transactions in the future.

Overview of the Deals to Date

The publically announced unrated CMBS transactions which have completed to date in Europe are as follows:

Click here to view the table.

Rationale for Issuing Unrated

There is no single reason why these transactions were issued without credit ratings. However, there are some general themes that appear to be common to many of the issuances to date which may provide some guidance as to when and where unrated CMBS will be issued in the future:

  • Transactions, such as DECO 2013-CSPK, that involved a smaller portfolio of properties than a typical CMBS transaction;
  • Smaller transactions which do not require wide marketing (e.g., Mint Mezzanine[2] and Midas[3]) and can be privately placed;
  • Transactions that could have been originated and placed in the syndications market, but the end investors preferred a capital markets investment (e.g., Mint Mezzanine, Midas, Zephyrus, and Reni). Such transactions are designed to be simple "pass throughs" of the underlying loans without any structural or credit enhancements and were arranged for particular investors who wanted to invest in the underlying loans but were better suited to invest their funds in fixed income instruments, such as CMBS bonds.[4] Such structures may also provide preferential regulatory treatment in some instances and for some investors (as described below);
  • In one situation (Utrecht), the transaction was arranged to permit certain existing investors to retain an interest in a refinanced transaction that was actually more akin to a restructuring. The investors did not appear to require ratings for their ongoing investment. This was an unusual situation for an unrated CMBS, but may be more common as some of the legacy CMBS vehicles wind down in the coming years with small but troubled asset pools; and

Advantages of Issuing Unrated

The overriding reason to issue unrated bonds in a CMBS is cost. Engaging a rating agency to rate a transaction will involve paying an upfront fee and an annual surveillance fee. Complying with rating criteria on an on-going basis will also involve costs. Finally, new regulation imposes further costs on rated securitisations.

  1. One of the most significant effects of the credit crunch has been that significantly fewer institutions have retained the high short term and long term credit ratings needed to allow them to provide the liquidity facilities, hedging and bank accounts necessary to support AAA/Aaa rated securitisations. At the same time, those institutions that have retained the requisite credit ratings face a significantly more onerous regulatory burden when they provide such arrangements with the introduction of measures such as the European Market Infrastructure Regulation (“EMIR”)[5] rules for derivatives and the imposition of significantly higher regulatory capital costs for providing liquidity facilities under Basel III[6] (which previously were treated favourably for regulatory capital purposes). This has led to a number of lending institutions to withdraw from the market entirely and those that remain to pass on their increased costs to the securitisations and ultimately the investors.

By way of illustration, the cost of arranging liquidity facilities for AAA/Aaa rated CMBS has changed as follows:

Click here to view the table.

As such, it can be seen that undrawn, post-credit crunch liquidity facilities are between four and five times as expensive as undrawn, pre-credit crunch facilities and more than twice as expensive when drawn.

In addition to requiring certain minimum credit ratings for key transaction parties upon issuance of the CMBS, ratings criteria for AAA/Aaa CMBS also requires that these parties agree to specific provisions in the transaction documents designed to maintain such ratings. As an example, hedge counterparties in a rated transaction are required to provide collateral for their hedging obligations upon a rating downgrade of such counterparty below a specified level. As a result of these additional, costly requirements, a rating compliant hedge will be more expensive than one that is not required to be rating compliant. Therefore, hedging that is not rating compliant is generally less costly for the related CMBS transaction.

Similar issues exist for liquidity facilities and guaranteed investment contracts that might be part of a CMBS transaction. There have been a few unrated transactions which have been issued without the use of any liquidity facility, instead only utilising a simple, expense reserve for the risk of unpaid costs that might arise as a result of non-payment of interest on the underlying loan pool. The lack of liquidity would add significant stress to the rating for any CMBS and is typically only achieved by transactions that are secured by a very granular pool of properties. Significant costs can be saved on a CMBS if there is no liquidity facility.

  1. Unrated CMBS transactions may (depending on how they are structured) benefit from exemptions to particular regulations and hence save certain compliance costs. Other forms of unrated CMBS may offer regulatory advantages to particular types of investors.

For rated transactions that will be offered to U.S. investors, Rule 17g-5 of the US Securities Exchange Act requires that such rated securitisations maintain an electronic archive of information provided to the rating agencies appointed to rate the transaction. This information is required to be available to other rating agencies in order to permit such other rating agencies to issue unsolicited ratings of the transaction. In order to comply with this rule, the arranger for the transaction will be required to appoint a party to take responsibility for this activity, to create procedures to record all information exchanges and to maintain a suitable website. Clearly, compliance with this rule results in additional costs for rated transactions.

In addition, a range of European regulations applies to transactions qualifying as “securitisations” within the meaning of the EU Capital Requirements Regulation (“CRR”)[9]. Broadly, these regulations define securitisations as transactions which feature tranched exposures to an “exposure” or pool of “exposures” (meaning, in the case of CMBS, CRE loans) where the subordination of tranches[10] 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, certain of which are subordinated to other classes.

One of the additional regulatory requirements for securitisations is contained in the Regulation for Credit Rating Agencies (“CRA III”).[11] Pursuant to CRA III, if a structured finance transaction is going to be rated, it must be rated by two credit rating agencies. Obviously, such requirement will add costs to a securitisation.

In addition, the regulatory capital treatment for investments by regulated investors in unrated, untranched CMBS is somewhat unclear. It would appear that such transactions, because of their lack of tranching, may not be treated as “securitisations” under the current Basel III and Solvency II rules. As such, there seems at present to be no specific guidance in the rules as to the regulatory capital treatment of unrated, untranched CMBS.

It has been suggested[12] that regulated investors in unrated, untranched CMBS applying the Internal Ratings Based (“IRB”) Approach under Solvency II or Basel III may “look through” the CMBS structure and treat the CMBS bonds as a direct investment in the underlying CRE loan for regulatory capital purposes. This could only be the case for “pass through” CMBS backed by a single CRE loan with no credit enhancements where the bonds directly mirror the terms of the underlying CRE loan as otherwise, it would not be possible to view the CMBS bonds as being effectively the same as the related CRE loan.

Depending on the terms of the underlying CRE loan in such an instance and, in particular, its LTV, such an approach could result in regulated investors achieving favourable regulatory capital treatment for such an investment.

It is notable that a number of the unrated CMBS transactions issued in Europe involved the issue of single tranches of bonds, primarily Reni SPV, Pangaea Funding, Mint Mezzanine and Midas Funding.[13] Reports suggest that the more favourable regulatory treatment of unrated, untranched CMBS may have been a factor in the structuring of some of these transactions.[14]

For unrated, untranched CMBS to receive favourable regulatory capital treatment would be inconsistent with the treatment of most 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 entered into either, in the case of conduit deals, to generate a profit for the arranger through the differential between capital markets pricing and loan market pricing or, in the case of agency transactions, to provide access to the capital markets and, therefore efficient funding, to the related borrower. In either case, both the pricing in the primary market for the CMBS as well as the start-up and on-going costs of the CMBS vehicle will have significant effects on the viability of the transaction. This is particularly important for conduit CMBS where profits are typically extracted through IO structures such as Class X Notes. These structures are sensitive to bond pricing and to recurring on-going costs such as liquidity facility commitment fees and hedging strike rates both of which will have impact on the profitability of the transaction for the sponsor of the CMBS.

Disadvantages of Issuing Unrated

The purpose of a credit rating is of course to provide investors with an independent expert assessment of the likelihood of the payments on the rated investment being made in full and on time. As such, a wider range of investors will be interested in rated investments than in 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. In addition, certain investors (particularly in the fund sector) are restricted by their constitutional documents from making unrated investments. Due to this, unrated investments have always been seen as less liquid than rated ones and this difference in liquidity has traditionally resulted in investors seeking a higher return for such unrated investments.

Recent changes in regulation have further reduced the liquidity of unrated investments (and in particular unrated tranched securitisations such as tranched CMBS) by making such investments increasingly unattractive for regulated investors. This has been achieved by imposing punitive capital treatment for unrated, tranched securitisation investments held by regulated investors under the Basel III rules.

In Europe, where the Basel rules take effect through the Capital Requirements Directive, the position of a particular regulated investor holding an unrated tranched CMBS will depend on whether it is permitted to use the Standardised Approach or the IRB.

Investments in unrated, tranched securitised bonds will generally[15] under the Standardised Approach either carry risk weightings of 1250 per cent. or require the regulated investor to make a full deduction from capital for such tranched securitised bonds.[16] Firms using IRB apply the supervisory formula approach to holdings of unrated tranched securitisation bonds. This involves using a complex formula based on the structure of the investment and the nature of the underlying assets to calculate the capital requirements for the investment. An analysis of the treatment of unrated tranched CMBS under the supervisory formula approach is beyond the scope of this article but it is understood to be very unfavourable.

Furthermore, regulated investors holding unrated tranched CMBS bonds, will generally not be able to finance their investment through schemes such as the ECB’s Long Term Refinancing Operation (“LTRO”) or the Bank of England’s Asset Purchase Facility (“APF”) as the eligibility criteria for these schemes generally require investments to be rated.[17]

Pricing Comparisons

It is difficult to find relevant direct comparisons between rated CMBS and unrated CMBS in the same jurisdictions and asset classes issuing around the same time due to relatively few transactions completing over recent years. Set out below are the only two examples where useful comparisons can be made:

Click here to view the table.

It can be seen from this that unrated CMBS prices at considerably higher levels than equivalent rated transactions. Clearly 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 as discussed above.

A Halfway House?

The expense and scarcity of liquidity facility providers, hedge providers and bank account providers meeting the requirements for AAA/Aaa rated transactions has resulted in a number of transactions recently being issued with maximum ratings of A/A2 (or lower). CMBS rated no higher than A/A2 face a less onerous set of ratings criteria and, in particular, generally do not require liquidity facilities. Recent examples of such transactions 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 without any credit ratings (as described above) and also avoiding the most punitive regulatory capital treatment given to unrated tranched transactions.

The analysis of the relative merits of issuing on a rated or unrated basis is a fine art and is subject to a large number of asset and market variables. In recent weeks, a specific example of this has been seen in the market in relation to the Antares 2015-1[18] transaction which is currently being marketed. Market commentators[19] have suggested that adding a liquidity facility to the structure would increase transaction costs by approximately 0.10 per cent. but this would allow the bonds to achieve an AAA/Aaa rating which would result in pricing on the bonds decreasing by approximately 0.14 per cent.

Privately Placed CMBS

The emergence of unrated CMBS transactions gives rise to a further interesting question; whether a true private placement market can be developed for European CMBS. The significance of this point is that arrangers of transactions could save considerable costs if investors do not rely on the arranger to prepare detailed disclosure documents but instead carry out their own due diligence on the transaction.

European CMBS is generally issued in the form of listed bonds for a number of reasons, namely: (a) preference of investors for listed bonds in order to enhance liquidity and (b) navigating through withholding tax issues relating to source income, debt instruments and cross border investment, particularly by non-bank investors,. These withholding tax issues can be overcome if the bonds issued qualify as “quoted Eurobonds” for tax purposes. For this to be the case, the bonds have to be listed on a recognised stock exchange.[20]

Most major stock exchanges permit securities to trade on either a regulated market or an unregulated market,[21] with lower disclosure requirements applying to the unregulated market, provided that the offering meets the exemptions for disclosure required under the Prospectus Directive.[22] A number of recent European CMBS transactions have traded on unregulated markets such as Mint Mezzanine 2014, which trades on the Global Exchange Market of the Irish Stock Exchange. However, the offering circulars for these deals are as detailed as those used for transactions trading on the main regulated markets of the stock exchanges[23] which demonstrates a reluctance in the market 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 through an electronic data room maintained by the arranger. However, this has not been seen to date in the market and at present there seems to be no consensus as to whether this would be acceptable to investors.

Conclusion

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 is driving the development of new forms of CMBS.

The development of products such as unrated CMBS and A/A2 CMBS without liquidity facilities 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.