DBRS Announces No Changes Are Needed in Its CMBS Rating Methodology

DBRS has announced that there are no changes needed in its CMBS Rating Methodology in light of today’s market conditions. The DBRS commercial mortgage-backed securities (CMBS) methodology and modeling approach have been mean-reverting from inception and included the realistic assumption that real estate is cyclical and that at some point, capitalization rates and cost of capital will return to a historical mean.

“The CMBS transactions we did not rate frequently had large adjustments to the issuer underwritten net cash flow, upward of 15%, demonstrating the inability of the property’s in-place cash flow to support the existing debt obligations,” says Jack Toliver, Managing Director of CMBS. “Recognizing the increased probability of default in and of itself fails to reflect the increased risk unless one recognizes that recoveries are likely to be less on a loan that is 120% LTV than on one that was 70% LTV, based on ACLI (American Council of Life Insurers) and (Howard) Esaki statistical data.”

At the core of DBRS analysis, we recognize “stabilized” in-place cash flow modeling instead of cash flow projections that may or may not be realized over the loan term. Within DBRS’s CMBS model, probability of default is a measure of the ability of our stabilized cash flow to meet contractual debt service obligations over the term of the loan and support refinancing of the balloon balance in an uncertain economic environment. As a result, the majority of the loans that we evaluated between 2006 and 2008, on a preliminary basis, were identified to contain a higher risk profile under these scenarios. Furthermore, DBRS’s property values recognized that the value of the underlying security is most important at balloon or in the event of a default within the term. Not only does DBRS recognize mean-reverting capitalization rates, but our model caps recovery for loans that exceed 95% loan-to-value (LTV).

This analysis is clearly identified in our methodology and consistently applied in our models, which prevented us from rating the vast majority of CMBS transactions issued between 2006 and 2008 because those transactions lacked sufficient initial credit support.

DBRS expects that delinquencies within the CMBS market will continue to rise as the market weathers this severe global economic downturn. As a result, there will likely be more downgrades in our CMBS portfolio within the next year and continuing well into 2010 as defaulted loans come to resolution. Lacking a prolonged collapse in the credit markets and assuming a return to equilibrium and some form of market liquidity, the downgrades will be a result of individual loan performance and not a broad-based methodology change. We also intend to use rating trends more frequently as early indicators for investors of the detection of credit changes within the loan pools. This will continue to highlight the proactive real-time surveillance we have always performed on each of the CMBS transactions we rate.

Our CMBS Rating Methodology is available at www.dbrs.com.