The delayed downgrade of bonds tied to a New York City office tower, 1740 Broadway, has sparked concerns over the reliability of credit rating agencies, after a failed property sale led to unexpected losses for investors. The bonds, once rated AAA, were downgraded to junk status by S&P and DBRS Morningstar over a year after the building’s owner, Blackstone Group, defaulted on the loan in March 2022 following the exit of its anchor tenant, L Brands.

The delay in downgrading these bonds resulted in a 26% loss for investors in the safest tranche of the commercial mortgage-backed securities (CMBS), marking the first loss on a AAA-rated bond since the 2008 financial crisis. This unexpected outcome has rattled financial markets that depend heavily on credit ratings to assess risk.

“Investor losses in 1740 Broadway, even at the AAA tranche, call to mind the ugly specter of 2007’s housing crisis and the ratings agencies’ participation in that horrific destruction of wealth,” said Paul Feinstein, CEO of Audent Global Asset Management.

The saga began when Blackstone handed over the building to investors after L Brands vacated in the aftermath of COVID-19. A potential sale of the property in late 2022, which could have repaid bondholders in full, ultimately collapsed as rising interest rates eroded property values. The lengthy sales negotiations meant that an independent appraisal, which could have reflected the building’s true market value, was delayed.

Without an up-to-date appraisal, rating agencies relied on outdated models, maintaining an overly optimistic view of the property’s worth. S&P, for instance, estimated the building’s value at $270.4 million in April 2022, which supported keeping the AAA rating intact at the time. However, a July 2023 appraisal valued the property at just $175 million, insufficient to cover what AAA bondholders were owed.

The delays in both the sale and the appraisal process resulted in the eventual downgrading of the bonds to BB+ by S&P, a rating below investment grade. This downgrade saw the value of the AAA bonds plummet from 90 cents to the dollar down to as low as 60 cents, as noted by Jeff Berenbaum, head of CMBS strategy at Citigroup.

Critics argue that this case highlights significant flaws in the timeliness and accuracy of credit ratings, with potential implications for other commercial mortgage-backed securities in the market. The situation underscores the need for more rigorous and timely evaluations to protect investors and maintain confidence in the financial system.

(Adapted from Reuters.com)

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