Sergi Reboredo/VWPics via AP Images
View of 1740 Broadway in New York, at left. The $605 million property was purchased by Blackstone in 2015 and sold this year for only $186 million.
Troubles in the commercial real estate (CRE) markets, which have been predicted for years, appear to be growing. Delinquency rates above 30 days on office building loans ticked up in June, representing close to $2 billion in losses, according to a report from Moody’s. Office vacancies are at a record high of slightly over 20 percent, and this has translated into loan defaults, stretching from the Illinois Center tower in Chicago to a suite of office buildings in Mountain View, California, in the heart of Silicon Valley.
A couple billion in defaults in a market valued around $20 trillion isn’t worth worrying about. But a significant chunk of CRE loans are starting to come due for the first time since the pandemic greatly increased working from home. Prices on commercial properties began dropping last spring for the first time since 2011, and regional and local banks, which are more exposed to these loans, are in a particularly precarious position. Regulators are even starting to talk about fraud and questionable valuations in these markets.
Experts have described CRE as “a train wreck waiting to happen.” But Moody’s is a company that’s supposed to have seen the train wreck coming. It is a credit rating agency, which assesses risks in bonds and securities and assigns a rating that reflects those risks. If losses in bonds backed by CRE were inevitable, the credit rating agencies should have built that into their models rather than assigning them super-safe ratings.
Now, however, we’re seeing large downgrades in commercial mortgage-backed securities (CMBS), the debt instruments that are tied to CRE loans. Those downgrades are at the highest in “recent memory,” analysts at Bank of America said last year, with 40 deals affected.
Ratings analyst Marc Joffe, a former Moody’s director now at the libertarian Cato Institute and California Policy Center, has filed a formal complaint with the Securities and Exchange Commission against one of the “Big Three” credit rating agencies, Standard & Poor’s. Joffe says S&P is violating rules in the Dodd-Frank Act that were meant to standardize ratings across asset classes.
He uses as an example CMBS, where AAA-rated debt is defaulting and experiencing downgrades. On the other extreme, bonds issued by states haven’t seen a default in nearly a century, yet many aren’t rated AAA at all. The fact that an actually safe instrument is rated low and a risky investment is rated super-safe suggests that S&P (and other rating agencies) are breaking the Dodd-Frank rules.
“This is an echo of the 2006-07 era,” Joffe told the Prospect in an interview, referring to the time period when rating agencies gave AAA ratings to dodgy residential mortgage-backed securities (RMBS) that then collapsed, triggering the Great Recession. He doesn’t think the two moments are totally equivalent, since RMBS were re-securitized into derivatives and distributed worldwide, magnifying the losses. But what’s similar is that investors in both instances were lured by promises of safe returns into buying inherently risky securities. “I don’t think this is the thing that will push us to recession, but it’s bad for the real estate market and insurance companies that have this paper,” he said.
In addition, states at little risk of default are paying more money to borrow because of the lower ratings. That affects state finances and ultimately taxpaying citizens, who must pony up more to cover the interest payments.
All of this violates a core principle that was put into law 14 years ago to protect financial markets: No matter the asset, that safe AAA rating is a promise that should actually mean something.
DODD-FRANK SECTION 938 IS CLEAR: All ratings symbols should be applied “in a manner that is consistent for all types of securities and money market instruments for which the symbol is used.” The SEC implemented this with Rule 17g-8(b), using broadly similar language to the statute.
But Joffe argues that state debt and CMBS are not rated consistently. The last time a state defaulted on its debt was Arkansas in 1933, at the low point of the Great Depression. That was a consequence of the worst economic conditions in American history, natural disasters that wiped out local crops like cotton, and a layering on of debt to build out state highways for the coming automobile boom.
For the past 91 years, no state has faced a similar fate, regardless of recessions or pandemics. Despite bold calls that municipal debt would crash during the Great Recession, including one famous appearance on 60 Minutes by analyst Meredith Whitney, states just churned along, paying their obligations. But today, S&P lists only 17 states with a secure AAA rating, while 28 have AA ratings, and four—Illinois, Kentucky, New Jersey, and Pennsylvania—are at A. (Montana is not rated at all.) This is for a debt instrument that hasn’t defaulted in nearly a century.
Joffe first highlighted this discrepancy in a UC Berkeley report in 2017. Essentially, he says that state debt should all be AAA. A lower rating translates to higher borrowing costs for states, costing many billions of dollars that flow directly from state revenues to the financial industry.
Henny Ray Abrams/AP Photo
Credit rating agencies failed to account for losses in bonds backed by commercial real estate in their rating models.
In his complaint to the SEC, Joffe contrasts state debt with a particular kind of CMBS: Single Asset Single Borrower (SASB) securities. Popularized after the financial crisis because they were seen as easier to analyze, these are not diversified collections of different office loans, where a loss in one could be offset elsewhere. SASB deals collateralize a single commercial property, like a mall, a hotel, or office building.
Joffe first started writing about these deals at his website back in 2015, finding seven SASB deals issued in prior years that received AAA ratings, which effectively connote almost no chance of default. “My argument was, even if it’s a rock-solid asset, some horrible thing could happen,” Joffe said. He cited mall shootings or the closure of anchor stores as potential disruptions that would take the single asset down. Essentially, the rise of SASB created a single point of failure.
The pandemic ended up being the “horrible thing” that rocked commercial real estate, and higher interest rates for refinancing didn’t help. But even before then, AAA-rated CMBS were struggling. In 2018, Joffe explained that one deal backed almost entirely by a single defaulted shopping mall was nonetheless still receiving an investment-grade rating. Moody’s was penalized the same year by the SEC for inconsistent ratings across asset classes, the very kind of violations of Dodd-Frank Section 938 that Joffe cites in his complaint.
Joffe lists five SASB bonds that were rated AAA between 2014 and 2016 that have “failed to pay interest on time or experienced a loss of principal.” This led to either a ratings withdrawal by S&P or a severe downgrade.
One of these, known as JPMorgan Chase Commercial Mortgage Securities Trust 2014-DSTY, was issued a decade ago to provide $430 million in financing for Destiny USA, a mall complex in Syracuse, New York, that is among the largest in the U.S. The mall is about $713 million in debt—five times its appraisal value—and continues to lose large stores, including At Home, Forever 21, Rue21, Lord & Taylor, JCPenney, and Best Buy. It has been negotiating for extensions on principal payments and default expectations are high.
A separate security backed by the Palisades Center in New York has also performed badly. Westfield San Francisco Centre, which the parent company gave up in 2023, has also lost numerous tenants, and lenders filed suit to foreclose on the property last October. Starwood Malls, a series of shopping centers backed by Starwood Capital Group, have been in distress for years.
BWAY 2015-1740 Mortgage Trust collateralizes the 26-story office tower at 1740 Broadway in Manhattan. That is a $605 million property purchased by Blackstone in 2015 that was sold this year for only $186 million. Investors in the AAA portion of the CMBS were repaid only 74 cents on the dollar, losing money for the first time in any mortgage-backed security since the financial crisis.
Some of the investors that lost money were insurance companies, which Joffe says are heavily invested in this type of security. Noting the general hike in insurance premiums, he said, “part of the insurance problem that we’re having right now is somewhat related to the meltdown in CRE.”
S&P has also downgraded three other CMBS bonds that were initially given AAA ratings. These bonds, which are now all below investment grade, are tied to, respectively, the Walden Galleria in Cheektowaga, New York, the Peachtree Center office and retail complex in Atlanta, and an office tower in the Financial District of San Francisco. A fourth bond, which collateralizes the Gas Company Tower in downtown Los Angeles, has been downgraded from AAA to B1 by Moody’s, as the county has stepped in to buy it to supplant its current, aging headquarters.
To Joffe, this spate of downgrades and defaults should never have happened, if AAA truly means what the rating agencies claim. The models that the rating agencies publicly ascribe to the AAA rating say that the property prices should never be valued lower than the amount of debt owed. But those values are now dropping routinely.
Eric Risberg/AP Photo
Two women sit outside an empty section of Nordstrom’s at the Westfield San Francisco Centre, June 21, 2023. The shopping mall has lost numerous tenants, and lenders filed suit to foreclose on the property last October.
Last month, The Wall Street Journal tracked several other purportedly safe SASB bonds. It listed 28 different such bonds where the underlying property loans are delinquent in some fashion. The Journal story cites a Federal Reserve Bank of Philadelphia report showing that half of all SASB bonds come due by the end of 2028. Because banks don’t want to realize losses on these bonds, their only other option is to keep them on their books, which would force them to account for that risk by holding more capital. That reduces lending in the economy more generally.
Some analysts have called the combination of events impossible to foresee. But rating agencies were still giving AAA ratings to SASB bonds after the pandemic, when the potential for losses in commercial real estate should have been well understood. “There are ones now that were packaged in 2021 and are now getting seriously downgraded,” Joffe noted, citing 1440 Broadway in New York City, a WeWork space that got a significantly lower valuation in reappraisal and whose CMBS has seen reductions in ratings. “The underlying mortgage has become delinquent,” he said.
Despite all this, CMBS issuance is continuing to rise, including in SASB, regardless of these delinquencies.
Joffe believes S&P should have changed its rating methodology for CMBS and state debt to better account for risk and make the ratings uniform. But S&P hasn’t meaningfully revised its rating criteria for CMBS since 2012, and for state debt since 2016. Yet S&P issued a research note in January 2020, before the pandemic, entitled “Shop with Caution—CMBS Mall Loans Worth Watching,” offering an example of a mall losing 75 percent of its value two years earlier. Nonetheless, and ignoring its own warning, the rating agency continued to rate these types of securities AAA without changing its reasoning.
S&P did not respond to a request for comment.
JOFFE FILED HIS WHISTLEBLOWER COMPLAINT (a whistleblower need not work at the company involved if they use public information to generate the complaint) about a month ago; he has not heard back from the SEC. The agency did not respond to the Prospect’s request for confirmation of the complaint. Joffe also said he held a Zoom meeting in 2021 with the Office of Credit Ratings, a supervisory body within the SEC. That did not lead anywhere.
Outside experts consulted by the Prospect agreed with the essence of Joffe’s argument. “This is a legitimate issue and the SEC has never dealt with it,” said Micah Hauptman, director of investor protection at the Consumer Federation of America (CFA), who previously worked as a counsel to SEC commissioner Caroline Crenshaw. “It allows different debt instruments to be treated differently, and allows risk to not be priced appropriately.”
Rating agencies have pushed back against the standardization of ratings. Ultimately, the SEC, while issuing the rule implementing part of Section 938 of Dodd-Frank, decided in 2012 to go no further, essentially agreeing with the rating agencies.
The Big Three rating agencies—S&P, Moody’s, and Fitch Ratings—control approximately 95 percent of the industry, although there are small rating agencies like Kroll and Morningstar. They are typically paid by the issuers of the securities, a major conflict of interest that was identified during the financial crisis. Rating agencies may be inclined to give good ratings to the issuer that pays them, in the hopes of getting more business. An attempt to change the issuer-pays model during Congress’s crafting of Dodd-Frank failed miserably.
Other experts point to the desire to manufacture securities that can attract institutional investors that buy the safe portion at the top, and speculative investors comfortable with taking on more risk at the bottom. This endless search for yield can distort the ratings process and give less scrutiny to cookie-cutter securities.
One problem with getting accountability for rating agencies is an obscure decision made by the SEC in 2010. Ford Motor Credit (FMC) wanted to promote an asset-backed security without putting its credit ratings in their registration statement. This would have violated Section 939G of Dodd-Frank, but the SEC went along with it by issuing a “no-action” letter, essentially giving FMC and anyone else the ability to do this. By eliminating rating agencies from the registration statement, it removes their Section 11 liability, which allows investors to sue over misrepresentations or omissions in a registration statement.
Current SEC Chair Gary Gensler and the Division of Corporation Finance could withdraw that no-action letter unilaterally, without new rules. A bipartisan group of issue-based groups and analysts asked the SEC’s Division of Corporation Finance to withdraw the FMC no-action letter in 2022. A separate letter from experts was sent in 2023 urging the SEC to subject rating agencies to Section 11 liability. But the letter’s policy remains in effect.
This is why rating agencies largely escaped liability for the financial crisis, and why lawyers for investors see little way to hold rating agencies accountable for failures today. “The possibility of private litigation is a vitally important avenue of recourse for investors against artificially inflated ratings that cause serious harm, and it would aid the transparent and efficient functioning of capital markets,” the bipartisan letter states.
The Consumer Federation’s Hauptman, who did not have conversations about this issue while at the SEC, pointed out that issuers of securities threatened to stop issuing debt if they were forced to put the ratings in the registration statement. He sees that threat as mostly empty. “It’s possible there would be some short-term impacts in the market, but in the long-term companies are still going to issue that debt and investors will buy it, and they need companies to assess the risks. I don’t think rescinding [the no-action letter] will fundamentally change that dynamic.”
