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A Fine Mezz, Defined

A new report by Moody’s Investors Service explains the rating agency’s baseline credit standard for mezzanine loans. The methodology is aimed at mezzanine lenders and CDO issuers, but offers lenders a useful insight into features that can improve a loan’s credit rating.

The overall credit rating of a commercial real estate collateralized debt obligation (CRE CDO) reflects the credit worthiness of the individual debts in the asset pool. But how are those debt – and particularly mezzanine loans – assessed by credit agencies?

In the report, Moody’s addresses this question by explaining its baseline credit standard for mezzanine loans. While the methodology targets mezzanine lenders and CDO issuers, it also offers lenders some useful insight into features that can increase a loan’s credit rating.

“Mezzanine loan makers probably find it helpful to have mezz loan borrowers who understand the baseline expectations,” says Daniel B. Rubock, a senior credit officer at Moody’s who authored the report.

Mezzanine debt – defined as a loan secured by an interest in the ownership entity of a property, rather than by the asset itself – is garnering extra attention from rating agencies due to a rapid proliferation of this lending form. In 2004, the volume of mezzanine debt included in CRE CDOs totaled just $25.6 million. By 2006, that annual volume had grown more than 100 fold to $3.2 billion. Rubock largely attributes this massive increase to CRE CDOs, which enable lenders to securitize mezzanine and other short-term debts.

“It’s a reflection of the increased popularity of the capital markets as an outlet for subordinate debt generally,” he says. “It used to be that the end game for subordinate debts were portfolio lenders, or the subordinate pieces would have been retained on the books of the issuer or some well-heeled investors,” Rubock explains. “[But] now they can be put into CDOs and securitized.”

In Moody’s report, which was issued March 29, the agency describes its baseline criteria for a neutral credit rating on a mezzanine loan. Much is contingent on the inter-creditor agreement, which is a master agreement between the lender on the senior loan and the mezzanine lender.

The inter-creditor agreement typically spells out to what degree the mezzanine lender can step into the borrower’s role in the event of a default on the mezz loan. For that reason, rating agencies evaluate the mezzanine lender’s ability to perform as the borrower on the senior debt.

“You want to know that your replacement borrower is as solid as the primary borrower, or at least meets a minimum standard,” Rubock says.

Because the inter-creditor agreement defines rights for both the senior and mezzanine lender, credit quality can deteriorate into a zero-sum game between the two loans. In other words, anything that increases the mezzanine lender’s flexibility and creditworthiness is likely to decrease the senior lender’s flexibility and the credit quality of the senior loan.

Yet an experienced mezz lender with the deep pockets necessary to weather a default on the mezzanine loan can be an advantage for the primary lender. In essence, the mezzanine lender serves as a backup to keep the primary mortgage in good standing, should the borrower fail to operate the property effectively.

Other features rating agencies look for are maturity dates in sync for both the primary and senior debt, and an interest rate cap on the mezzanine loan, which will typically carry a floating rate.

Both lenders and borrowers could benefit from a better understanding of how ratings agencies assess mezzanine loans, says Hessam Nadji, managing director of research services at Marcus & Millichap.

“The rating agencies are going to influence the spreads,” Nadji explains, referring to the spread between baseline interest rates and the interest rates that borrowers charge on a loan. “If they assign a higher risk rating, whether it’s in the CDO market or the CMBS market, that is going to increase the cost of borrowing for those instruments.”

As spreads widen, too, a good credit rating is becoming increasingly more important. “We’ve seen some volatility in the CMBS spreads, due to subrime concerns a month or six weeks ago,” Nadji says. “They’ve stabilized, but they do remain sort of ‘on watch.’”

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