Credit agencies have misrated more than $100 billion in commercial real estate debt in an increasingly popular segment of the market, mortgage veterans say, including at least a dozen deals that maintain top investment-grade ratings even as borrowers default.
The questionable ratings appear in a part of the mortgage-backed bond market that has evolved over the past decade or so, where deals are backed by a single loan or mortgage on a single large office building rather than a parcel of multiple properties.
One-time loans now account for about 40 percent of the nearly $700 billion in outstanding commercial mortgage bonds. Developers like them because they can get better terms than simply borrowing from a bank. Investors like these deals because they tend to have floating interest charges, which insulates them from the high-rate environment of recent years.
One of those stores is 1407 Broadway, a 48-story tower in New York’s garment district that is facing foreclosure. The owner, San Francisco-based Shorenstein Properties, has defaulted on the mortgage since July on the building, which no longer generates enough rent to cover costs and interest payments.
However, the $187 million in bonds tied to the building’s debt is still rated AA by Fitch — a rating the agency says is reserved for borrowers with “very high credit quality” and debt with a “low risk” of default.
For most high-rated mortgage bonds, a single loan default may not affect the loan’s rating or the investor’s ability to repay. But the $350 million bond deal for 1407 Broadway, more than half of which was rated AAA, is backed by the fortunes of 1407 Broadway itself.
Deals like 1407 Broadway draw comparisons from people like Rod Dubitsky, a former credit analyst at Moody’s and Credit Suisse, to the problems that led to the financial crisis, when rating agencies like Moody’s and S&P gave AAA ratings to bonds that were almost entirely backed by subprime borrowers.
“It’s probably and easily the worst example of major misjudgment that exists today,” says Dubitsky, who publishes articles on social media sites such as The People’s Economist. “The integrity of the assessment process has improved very little [since the financial crisis].”
Observers say rating agencies are loathe to admit they misjudged the AAA deal and are therefore reluctant to downgrade.
Fitch said through a spokesman that the agency had downgraded the 1407 Broadway bond from AAA and was on alert for further downgrades. As for the quality of ratings on single-loan deals, a Fitch spokesman said the firm could not comment on industry-wide data and that approaches differed among rating agencies.
Moody’s and S&P, which also issue single-asset bond ratings but did not rate 1407 Broadway, declined to comment for this article.
The AAA rating is meant to indicate that the borrower’s risk of default is extremely low. Of the companies in the S&P 500, only two have AAA ratings, software giant Microsoft and drugmaker Johnson & Johnson.
“You should never take a loss on AAA-rated bonds,” says Ethan Penner, an investment banker who helped create the first commercial mortgage-backed bond in the early 1990s. “The three letters ‘AAA’ next to the bond mean the world could end and you would have no losses.”
However, a number of AAA-rated deals are looking increasingly risky. Dubitsky, a former Moody’s credit analyst, has created a list of what he calls the “Dirty Dozen” bond deals that were either originally rated AAA or still are even though the borrower is either in default or in default. Ark Capital Advisors, for example, defaulted on its mortgage on San Francisco’s 600 California Street office tower in March 2023 and now owes more than $9.5 million in back payments. The bonds, originally rated AAA, are now trading at 74 cents on the dollar, according to Bloomberg.
In addition to 1407 Broadway, Shorenstein is also behind on his mortgage at 1818 Market Street, a downtown Philadelphia tower with 1 million square feet of office space. Shorenstein first missed a loan payment in August and is now more than $3 million behind. This month, the mortgage servicer decided to declare Shorenstein not in default after the borrower applied for a loan modification. 1818 Market Street’s $75 million one-time loan bond sold to investors in 2021 is still rated AAA by both S&P and DBRS Morningstar.
Critics have warned that, because they lack diversification, ratings on commercial mortgage-backed bonds are not as credible as ratings on other bonds. Marc Joffe, who worked for Moody’s mortgage debt rating in the mid-2000s and is now a policy analyst at the Cato Institute, wrote about his concerns about single-asset deals in 2015 in relation to the risks associated with older shopping centers that were then they use to support these stores.
In mid-2020, the Federal Reserve refused to accept single-loan CMBS as collateral for short-term loans under the Covid-era emergency lending facility.
Scrutiny of those deals increased recently after investors lost 26 percent of their initial investment in a bond originally rated AAA and backed by a single building — the former Manhattan headquarters of insurance firm MONY at 1740 Broadway. The building was purchased by Blackstone for $605 million in 2014, but was recently sold in foreclosure for just $186 million.
“I think the credit rating agencies need to take responsibility, like we did with housing and the financial crisis,” Joffe said. “We have an asset class that has been proven to be flawed and yet we have more and more deals getting AAA ratings that they don’t deserve.”