CMBS Subordination, Ratings Inflation, and Regulatory‐Capital Arbitrage

• DOI: http://doi.org/10.1111/fima.12183
• Date: 01 March 2018
• Published date: 01 March 2018

CMBS Subordination, Ratings Inflation,

and Regulatory-Capital Arbitrage

Richard Stanton and Nancy Wallace∗

Using detailed origination and performance data on a comprehensive sample of commercial

mortgage-backed security (CMBS) deals, along with their underlyingloans and a set of similarly

rated residential mortgage-backed securities (RMBS), we apply reduced-form and structural

modeling strategies to test for regulatory-capital arbitrage and ratings inflation in the CMBS

market. We find that the spread between CMBS and corporate-bond yields fell significantly for

ratings AA and AAA after a loosening of capital requirements for highly rated CMBS in 2002,

whereas no comparable drop occurred for lower rated bonds (which experienced no similar

regulatory change). We also find that CMBS rated belowAA upgraded to AA or AAA significantly

faster than comparableRMBS (for which there was no change in risk-based capital requirements).

We use a structural model to investigate these results in more detail and find that little else

changed in the CMBS market overthis period except for the rating agencies’ persistent reductions

in subordination levels between 1997 and late 2007. Indeed, had the 2005 vintage CMBS used

the subordination levels from 2000, there wouldhave been no losses to the senior bonds in most

CMBS structures.

The rating agencies have taken a large share of the blame for the recent financial crisis.1For

example, Tomlinson and Evans (2007), in a Bloomberg report on the subprime crisis, quote

Satyajit Das, a former banker at Citigroup: “The models are fine. But they have an input problem.

It becomes a number we pluck out of the air. They could be wrong, and the ratings could be

misleading.” The same report quotes Brian McManus, head of CDO Research at Wachovia:“With

CDOs, they underestimated the volatility of the subprime asset class in determining how much

leverage was OK.”

Before concluding that the rating agencies were to blame, however, it is important to control

for the many other factors affecting these markets. For example, it is well documented that

there was a significant drop in the quality of residential mortgages in the years preceding the

financial crisis, especially in the subprime sector, fueled by both lower underwriting standards

and dishonesty on the part of borrowers and lenders (see, e.g., Demyanyk and Van Hemert,

We thank Chris Downing for invaluable research assistance. For helpful comments and discussions, we are grateful to

an anonymous referee, John Griffin, Dwight Jaffee, Atif Mian, Matthew Richardson, Ren´

e Stulz, Adi Sunderam, Otto

VanHemert, James Vickery, Maisy Wong, and seminar participants at the University of California, Berkeley; Ohio State

University; New YorkUniversity; Stockholm School of Economics; Sveriges Riksbank; 2010 National Bureauof Economic

Research conference on Market Institutions and Financial Market Risk; 2011 Western Finance Association meetings;

2011 National Bureau of Economic Research Summer Institute; 2013 National Bureauof Economic Research workshop

on the Economics of Credit Rating Agencies; 2013 American Real Estate and Urban Economics Association meetings;

and 2011 CreditRisk Evaluation Designed for Institutional Targeting in FinanceConference on Stability and Risk Control

in Banking, Insurance,and Financial Markets. Our work benefited from financial support from the FisherCenter for Real

Estate and Urban Economics.

∗RichardStanton is a Professor of Finance and Real Estate in the Haas School of Business at the University of California,

Berkeley,in Berkeley, CA. Nancy Wallaceis a Professor of Finance and Real Estate in the Haas School of Business at the

University of California, Berkeley,in Berkeley, CA.

1For discussion, see Bank for International Settlements (2008).

Financial Management •Spring 2018 •pages 175 – 201

176 Financial Management rSpring 2018

2011).2Many have also blamed problems in the credit default swap market.3Given all of these

confounding factors, it has proved hard to extract the separate role of the rating agencies in the

recent crisis, despite the wealth of anecdotal evidence, and there has been little empirical work

on this question in the academic literature.4Another related factor often blamed for the financial

crisis is regulatory-capital arbitrage, defined by the Basel Committee on Banking Supervision

(1999, p. 9) as “the ability of banks to arbitrage their regulatory capital requirement and exploit

divergences between true economic risk and risk measured under the [Basel Capital] Accord.”5

For example, Acharya and Richardson (2009, p. 197) state, “But especially from 2003 to 2007,

the main purpose of securitization was not to share risks with investors, but to make an end

run around capital-adequacy regulations. The net result was to keep the risk concentrated in the

financial institutions—and, indeed, to keep the risk at a greatly magnified level, because of the

overleveraging that it allowed.”6Opp, Opp, and Harris (2013) argue that, especially for complex

securities, regulatory distortions like this can reduce or eliminate the incentive for rating agencies

to acquire information, in turn leading to rating inflation.

In this article, we shed new light on the role of the rating agencies and regulatory-capital arbi-

trage in the crisis by focusing on the commercial mortgage-backed securities (CMBS) market.7

There are several reasons why the CMBS market is ideal for this purpose. First, we have access

2On April 12, 2010, Senator Carl Levin, D-Michigan, chair of the US Senate Permanent Subcommittee on Investigations,

issued a statement before beginning a series of hearings on the financial crisis. In the statement, he addressed some of

the lending practices of Washington Mutual, the largest thrift in the United States until it was seized bythe government

and sold to JPMorgan Chase in 2008 (see US Senate Press Release, “Senate Subcommittee Launches Series of Hearings

on Wall Street and the FinancialCrisis,” April 12, 2010). Among other allegations, the statement claims:

One FDIC review of 4,000 Long Beach loans in 2003 found that less than a quarter could be properly sold to

investors. A 2005 review of loans from twoof Washington Mutual’s top producing retail loan officers found

fraud in 58% of the loans coming from one loan officer’s operations and 83% from the other. Yet those two

loan officers continued working for the bank for three years, receiving prizes for their loan production. A

2008 review found that staff in another top loan producer’s office had been literally manufacturing borrower

information to speed up production.

Documents obtained by the Subcommittee also showthat, at a critical time, Washington Mutual selected loans

for its securities because they werelikely to default, and failed to disclose that fact to investors. It also included

loans that had been identified as containing fraudulent borrower information, again without alerting investors

when the fraud was discovered. An internal 2008 report found that lax controls had allowed loans that had

been identified as fraudulent to be sold to investors.

3See Stulz (2010) for a detailed discussion. Stanton and Wallace (2011) show, for example, that during the crisis, prices

for ABX.HE indexed credit default swaps, backed by pools of residential mortgage-backed securities (RMBS), implied

default rates over 100% on the underlying loans, and were uncorrelated with the credit performance of the underlying

loans. Many institutions incurred large losses through using ABX.HE prices to mark their mortgage-backed security

holdings to market.

4Notable exceptions include Ashcraft, Goldsmith-Pinkham, and Vickery (2010), who study credit ratings in the RMBS

market, and Griffin and Tang (2012), who look at collateralized debt obligation (CDO) ratings.

5For detailed discussions of regulatory-capital arbitrage, see, for example, Jones (2000), Basel Committee on Banking

Supervision (1999), Altman and Saunders (2001), Alexander and Baptista (2006), Kashyap, Rajan, and Stein (2008),

Acharya and Richardson (2009), and Acharya et al. (2010).

6The International Monetary Fund (2008, p. 31) reports that aggregate assets held by the 10 largest publicly traded banks

in the United States and Europe grew between 2004:Q2 and 2007:Q2 from about 8.7 to 15 trillion euros. Over the same

period risk-weighted assets, which determine the capital requirements of these institutions, grew significantly less, from

3.9 to about 5 trillion euros.

7Before the recent financial crisis, the US CMBS market had expanded rapidly, with an average annual growthrate of

18% from 1997 to 2007, at which point it stood second only to commercial banks as a source of credit to the commercial

real estate sector. By the end of the third quarter of 2007, outstanding CMBS funded $637.2 billion, commercial banks