Lending institutions have misrated more than $100 billion of commercial real estate debt in an increasingly popular segment of the market, mortgage veterans say, including at least a dozen deals that maintain the highest investment grade rating even though the borrowers are in default.
The questionable ratings emerge in a part of the mortgage bond market that has developed over the past decade, in which deals are backed by a single loan or mortgage on one large office building rather than on a bundle of multiple properties.
Single loans now represent 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 are positive about the deals because they often involve variable interest charges, which protects them against the high interest rate environment of recent years.
One of those deals involves 1407 Broadway, a 48-story tower in New York City’s garment district that is on the verge of closing. The owner, San Francisco-based Shorenstein Properties, has not made a payment since July on the mortgage for the building, which no longer generates enough rent to cover costs and interest payments.
Nevertheless, Fitch still rates $187 million of bonds tied to the building’s debt at AA – a rating the agency says is reserved for borrowers with “very high credit quality” and “low risk” debt default.
For most highly rated mortgage bonds, one loan default may not affect the rating or an investor’s ability to be repaid. But the $350 million bond deal for 1407 Broadway, more than half of which was AAA-rated, is buoyed by 1407 Broadway’s fortunes alone.
Deals like 1407 Broadway are causing people like Rod Dubitsky, a former credit analyst for Moody’s and Credit Suisse, to draw comparisons to the problems that led to the financial crisis, in which ratings agencies like Moody’s and S&P gave AAA ratings to bonds that were almost fully backed by subprime borrowers.
“It is probably and by far the worst example of misjudgment of large impacts that exists today,” said Dubitsky, who publishes articles on social media as The People’s Economist. “The integrity of the assessment process has improved very little [since the financial crisis].”
Observers say rating agencies don’t want to admit they misrated a AAA deal and are therefore reluctant to downgrade.
Fitch said through a spokesperson that the agency downgraded AAA’s 1407 Broadway bond and was monitoring it for further downgrades. Regarding the quality of ratings for individual loans, the Fitch spokesperson said the company could not comment on industry-wide data and that approaches varied by rating agency.
Moody’s and S&P, which also issue ratings on single-asset bonds but did not rate 1407 Broadway, declined to comment for this article.
AAA ratings are supposed to indicate that the risk of a borrower defaulting is extremely low. Of the companies in the S&P 500, only two have a AAA rating: software giant Microsoft and drug manufacturer Johnson & Johnson.
“You should never take a loss on a AAA-rated bond,” says Ethan Penner, an investment banker who helped create the first commercial mortgage bonds in the early 1990s. “The three letters ‘AAA’ next to a bond imply that the world could end and you won’t suffer any losses.”
Still, some AAA-rated deals are looking increasingly risky. Dubitsky, the former Moody’s credit analyst, has compiled a list of bond deals, which he calls the “Dirty Dozen,” that initially had or still have AAA ratings even though the borrower is delinquent or in default. For example, Ark Capital Advisors fell behind on the mortgage on the 600 California Street office tower in San Francisco in March 2023 and now owes more than $9.5 million in back payments. According to Bloomberg, the bonds, which were originally rated AAA, now trade for 74 cents on the dollar.
In addition to 1407 Broadway, Shorenstein is also behind on its mortgage on 1818 Market Street, a tower in downtown Philadelphia with 1 million square feet of office space. Shorenstein missed his loan payments for the first time in August and is now more than $3 million in arrears. This month, the mortgage servicer declared Shorenstein in default after the borrower requested to modify the loan. Yet 1818 Market Street’s $75 million bond, which sold to investors in 2021, still has a AAA rating from both S&P and DBRS Morningstar.
Critics have warned that single-loan commercial mortgage bond ratings, because they lack diversification, are not as reliable as other bond ratings. Marc Joffe, who worked for Moody’s mortgage debt in the mid-2000s and is now a policy analyst at the Cato Institute, wrote in 2015 about his concerns about single-asset deals related to the risks associated with older malls, which at the time were used to underwrite these deals to support.
The Federal Reserve declined to accept single-loan CMBS bonds as collateral for short-term loans in a Covid-era emergency lending facility in mid-2020.
Scrutiny of these deals has increased recently after investors lost 26 percent of their initial investment in a bond with an original AAA rating backed by a single building: the former Manhattan headquarters of insurance company MONY at 1740 Broadway. The building was purchased by Blackstone in 2014 for $605 million, but was recently sold through foreclosure for just $186 million.
“I think the rating agencies should take responsibility, like we did with residential mortgages and the financial crisis,” Joffe said. “We have an asset class that has been proven to be flawed, and yet there are still more deals going on that are getting AAA ratings that they don’t deserve.”