CMBS: Moody’s
Approach to Rating
Floating Rate Transactions
John Junyu Chen and Commercial mortgage-backed securities
Milton Chacon (CMBS) collateralized by floating rate loans
(floaters) have become an important part of
the CMBS market. Because they typically
have low prepayment penalties and short
lock-out periods, floaters have generally
appealed to borrowers with transitional assets
or short-term holding horizons. However,
based on their interest rate expectations,
some conduit borrowers may opt for floaters
as a flexible financing alternative that will
provide them with the opportunity to refi-
Chen
nance in a more favorable interest rate
environment.
Moody’s approach to rating floating rate
CMBS transactions shares the same method-
ology as that used for fixed-rate CMBS, except
for an additional step necessary to assess the
credit risk associated with floating interest rates.
First, Moody’s reviews the collateral perfor-
mance and determines stabilized cash flows.
A fixed-rate-based baseline credit enhance-
ment is derived using Moody’s debt service
Chacon coverage ratio (DSCR), loan to value (LTV)
ratio and asset quality grade. In the next step,
interest rates are stressed to determine the
credit enhancement adjustment necessary to
compensate for floating rate risk. This adjust-
ment incorporates the impacts of both
potentially higher interest advancing costs
and additional term defaults associated with
the interest payment volatility.1 The default
frequency at balloon is the same for both
fixed-rate and floating rate CMBS. This
adjustment is further calibrated to reflect the
joint probability of simultaneous interest rate
and real estate stresses. As in the fixed-rate
CMBS rating methodology, the final step
consists of portfolio adjustments for elements
such as diversity, structural characteristics and
quality of underwriting.
MARKET DRIVERS
The CMBS market currently offers commer-
cial real estate borrowers two primary
financing alternatives: long-term fixed-rate
and short-term floating rate loans.2 Long-term
fixed-rate loans typically have ten-year terms,
20-year to 30-year amortization schedules
and strong call protection.3 This level of
prepayment protection provides investors
more certainty in cash flows and has helped
make the current CMBS interest only (IO)
market viable.
Long-term fixed-rate financing typically suits
the needs of long-term borrowers with stabi-
lized assets. On the other hand, floating rate
financing is more attractive to borrowers that
require prepayment and refinancing flexi-
bility due to the transitional nature of the real
estate asset or the borrower’s expected short
holding period. In addition, traditional
conduit borrowers with stabilized assets may
also consider floating rate loans. These
borrowers anticipate that interest rates will
decline at some point over the next few years,
at which time they will prepay their loans
and lock in more favorable fixed-rate
financing.4
A CMBS floating rate loan typically has a
two-year to five-year term and provides for a
one-year or two-year contractual extension.
The prepayment penalties are less onerous
than their fixed-rate counterpart and may
include a short lock-out period followed by a
stepping down percentage penalty, as
opposed to the potentially very expensive
prepayment costs associated with yield main-
tenance and defeasance. Floaters are often
interest only loans, so the initial coverage is
typically higher than for equivalent amor-
tizing fixed-rate loans.
summer 2000 7
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
The Impact of Floating Interest Rate on
Expected Loss
Moody’s analysis of the credit impact of floating rate
loans is based on the expected loss concept, which incor-
porates both default frequency and loss severity. The
frequency of default during the loan term is generally
determined by the borrower’s ability to make debt
service payments based on the property’s cash flow.
Either a decline in property cash flow or an increase in
debt service can increase term default frequency. Balloon
default frequency depends on the interest rate environ-
ment and balloon balance at the time the loan matures.
If the balloon balances are the same, both floating and
fixed-rate loans bear the same refinancing risk.
The loss severity represents realized losses on a CMBS
collateral pool, and servicer advancing of default interest
is assumed. Therefore, the loss severity has three major
components: property value losses, workout costs, and
advancing costs. Property value losses result from
declines in the property values below the outstanding
loan amounts, due to either reduced cash flows or rising
capitalization rates. Workout costs include special
servicing fees, legal costs and other third party fees.
Advancing costs result from the servicer’s obligation to
advance unpaid debt service on defaulted loans.10 Upon
final disposition of the defaulted asset, the servicer is
reimbursed all advanced debt service and interest
thereon, before any principal distributions are made to
the certificate holders. Higher interest advances hence
result in higher realized losses to the trust.
Chart 2: The Incremental Impact of Floating Interest Rates on CMBS
Default Frequency
Balloon Defaults No impact; floating and
fixed-rate loans have
the same refinance risk
at balloon
Term Defaults Higher; floating rate
loans have higher term
default frequency due
to interest rate volatility.
The incremental credit impact of interest rate volatility
on floating rate loans as compared to fixed-rate loans,
assuming no interest rate caps, can be broken into default
frequency and loss severity components, as shown in
Chart 2 and summarized as follows:
• Default Frequency: The floating interest rate has no
impact on balloon default frequency since both fixed
and floating rate loans will face the same refinance
environment. However, it could affect the term
default frequency because rising interest rates may
cause additional defaults during the loan term due to
the mismatch between stable property cash flows and
rising debt service.11 The probability of floating rate-
induced additional term defaults depends on the
stressed interest rate as well as the capacity of the
property’s cash flow to absorb rising debt service.
Such capacity is reflected in the loan’s break-even
interest rate.12
• Loss Severity: For loans that would have defaulted
under the related fixed-rate stress scenario, the
severity of loss associated with property value losses
and workout costs for these defaults are assumed to be
unaffected by the floating rate. However, interest
advancing costs will be higher if interest rates rise
during the related workout period when a floating rate
loan defaults, as the advancing rate is based on the
then current interest rate. In contrast, after a fixed-rate
loan defaults, the servicer is required to advance
interest payments at the stated fixed-rate to the
CMBS certificate holders. The additional advancing
costs, if any, are deducted from the final liquidation
proceeds, resulting in a higher loss severity in the
event of default. For loans that default during the term
due to the floating rate feature, i.e. potentially higher
interest payments, the loss severity is expected to be
lower than defaults caused by changes in real estate
values. The losses on additional term defaults caused
by interest rate volatility come primarily from
workout and advancing costs.
x Loss Severity = Credit Loss
Higher; floating
rate loans may incur
Higher; potentially
additional interest
higher term default
advancing costs.
frequency and greater
loss severity due to
Severity depends on higher interest
whether a default is advancing costs
real estate or interest
rate related
Joint Interest Rate and Real Estate Stress
Moody’s has further considered the likelihood of both
real estate and interest rate stress occurring simultane-
ously. For example, arguments can be made that a severe
real estate recession would typically be associated with a
severe general demand contraction, during which period
interest rates would be unlikely to rise to a high stress
level. However, it would not be unlikely that a higher
interest rate environment could coincide with a property
summer 2000 9
 CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)

market downturn. Moody’s believes that the floating rate
adjustment should not be a pure addition to the baseline
credit enhancement, therefore a joint probability factor
is applied to the floating rate adjustment to reflect the
possibility of both real estate and interest rate stress not
occurring during the same period.13
CALCULATING THE FLOATING RATE
CREDIT ENHANCEMENT ADJUSTMENT
Moody’s has developed a CMBS floating rate approach
to quantify the credit enhancement adjustment neces-
sary to compensate for the floating rate risk. The
approach incorporates loan specific inputs such as term
to maturity, terms of borrower extension options, DSCR
and LTV ratios, spread over LIBOR and the strike rate of
the interest rate cap if one exists. This loan specific infor-
mation, together with the stressed interest rate
assumptions discussed above, is used to calculate an
adjustment for each rated class of securities.
To illustrate our approach, we have selected three
sample floating rate loans representing different levels of
leverage with Moody’s LTVs of 65%, 85% and 95%.
Chart 3 presents the calculation of floating rate credit
enhancement adjustments for these three loans. In this
example, the calculation is focused on the Aa2 class,
however the same methodology applies to other rated
tranches by varying the levels of interest rate stress
together with incremental default frequencies and addi-
tional advancing costs.
The following is a step by step explanation of the proce-
dure for calculating the floating rate credit enhancement
adjustment for a loan with a Moody’s LTV of 85%, as
shown in Chart 3. The same procedure applies to the
other two loans as well. The loan is assumed to have a
three-year term plus a one-year extension, a spread of 2%
over LIBOR, and no interest rate cap. For this example,
the stressed interest rate for the Aa2 rating level is
14.25%, the sum of the stressed LIBOR of 12.25% and
the spread of 2%. The breakeven interest rate is calcu-
lated by dividing the property’s net cash flow by the loan
amount. There are four steps involved in the calculation
of floating rate credit enhancement adjustment:
• Step 1: Evaluate baseline default frequency. Using
Moody’s fixed-rate rating methodology, assume that 22
points of credit enhancement are deemed necessary for
an Aa2 rating, prior to considering floating rate risk.
This credit enhancement considers a 55% default
frequency and a 40% loss severity.
• Step 2: Calculate additional loss severity. For the base-
line default frequency (55%), additional loss severity
occurring due to increased interest advancing costs
needs to be determined. The additional advancing rate
per year is calculated as the difference between
Moody’s hurdle rate of 9.25% and the Aa2 stressed
interest rate of 14.25%, or 5%. Allowing for an average
workout period of 1.5 years, the total additional
advancing costs would represent an incremental loss in
the event of default of 7.5% (1.5 years x 5%). The

Chart 3: Example of Calculating an Aa2 Floating Rate Credit Enhancement Adjustment

Loan (1) Loan (2) Loan (3)

Moody’s LTV 65% 85% 95%

Breakeven mortgage rate 15.38% 11.76% 10.53%
Stressed interest rate for an Aa2 rating 14.25% 14.25% 14.25%
Step 1: Base case analysis (based on fixed-rate)
Aa2 default frequency 35% 55% 90%
Step 2: Additional Loss Severity due to floating rate
Annual additional interest advancing costs 5.0% 5.0% 5.0%
Total additional interest advancing costs (1.5 years) 7.5% 7.5% 7.5%
Credit loss due to additional advancing costs 2.6% 4.1% 6.8%
Step 3: Additional Term Defaults due to floating rate
Additional term default frequency 12% 22% 10%
Loss severity of interest related defaults 16% 20% 24%
Credit loss due to additional term defaults 1.9% 4.4% 2.4%
Step 4: Credit Enhancement Adjustment
Aggregate Additional Credit Loss 4.5% 8.5% 9.2%
Joint Stress Probability 65% 65% 65%
Floating Rate Credit Enhancement Adjustment 2.9% 5.5% 6.0%

10 CMBSWORLD
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
product of 7.5% (additional advancing costs) and the
55% (baseline default frequency for Aa2) results in
approximately 4.1 points of additional credit loss at
the Aa2 rating.
• Step 3: Estimate additional term defaults. As a result of
interest rate stress for an Aa2 rating, an additional term
default frequency of 22% is estimated based on the
likelihood of the breakeven mortgage rate being lower
than the stressed interest rate, bringing the total default
frequency to 77% (55% + 22%). This estimate
considers the option value for borrowers not to default
immediately when the stressed interest rate exceeds
the breakeven rate, as well as the probability distribu-
tion of future property cash flows. The loss severity for
the additional term defaults is primarily due to
workout and interest advancing costs, estimated at
20%. Therefore, the additional credit loss from addi-
tional term defaults is 4.4 points (22% x 20%).14
• Step 4: Determine floating rate credit enhancement
adjustment. Based on step 2 and step 3, the aggregate
credit loss is 8.5%. (4.1% + 4.4%). However, the
chance of an extreme interest rate environment and a
severe real estate recession occurring simultaneously is
not very high. Therefore at an Aa2 rating level, a 65%
joint stress probability is applied to the floating rate-
related credit loss of 8.5%, resulting in the final floating
rate credit enhancement adjustment of 5.5 points
(65% x 8.5%).
Chart 3 also presents the calculation for the other two
loans with low and high leverage. The floating rate
adjustment is lower for the low leverage loan (2.9%) and
higher for the high leverage loan (6.0%). Note that the
additional term default frequency for the high leverage
loan is capped at 10% because the baseline stressed
default frequency is already 90%.
In general, the floating rate credit enhancement adjust-
ments have the following characteristics:
• The floating rate credit enhancement adjustment
increases with leverage, everything else being equal. For
example, an investment grade loan may have a floating
rate adjustment that is only half of the adjustment
required for a loan with conduit-type leverage. This
difference in the penalty reflects the capacity of the
investment grade loan to absorb higher interest rate
increases during the term without causing a loan default.
• The floating rate penalty levels off at a Moody’s
leverage of 95% to 100%. At the high rating levels,
most of the highly leveraged loans in the pool are
already assumed to default even under our fixed-rate
stress scenarios, therefore the floating rate penalty
consists mostly of the increased advancing costs
resulting from stressed interest rate scenarios.
• The floating rate credit enhancement adjustment is
higher for loans with longer terms to maturity, inclu-
sive of contractual extensions. All contractual
extensions are assumed to be exercised in our analysis.
Higher interest rate assumptions are used for longer-
term loans to reflect the increased uncertainty about
interest rate levels over a longer horizon.
• Floating rate loans are often interest only. Additional
credit enhancement may be necessary due to the lack
of loan amortization, in addition to the floating rate
credit enhancement adjustments.
INTEREST RATE CAPS
The above example illustrates the floating rate credit
enhancement adjustment with no interest rate caps.
Often, borrowers are required by lenders to purchase
interest rate caps to mitigate rate volatility during the
loan term. An interest rate cap has two primary credit
benefits: (1) reducing the additional default frequency
during the term, and (2) reducing the interest payment
shortfall, until the cap expires, for loans that do default
during the term. Moody’s prefers that the cap issuer be
rated at least Aa2 to receive the full benefit for the
interest rate cap.
Timing of Defaults
To determine the benefit of a cap, it is necessary to
consider the timing of defaults. Lower leverage loans will
generally take longer to default since the likelihood of
short-term credit deterioration is lower, and shorter term
loans will tend to have more defaults closer to the
balloon date. Chart 4 presents an illustration for a loan
with a 3-year term. Assume that an all-in interest rate
cap with a strike rate of 9.25% is purchased for the loan
term, and that on average it will take 18 months to work
out a defaulted loan. Should interest rates rise shortly
after the loan is originated, and the all-in rate for the
sample loan becomes higher than 9.25% for the next five
years, there are three possible scenarios for the timing of
default and the related advancing costs.
• Scenario 1: The loan defaults at the end of the first
year and is being worked out while the cap is still in
effect. The loan experiences no advancing costs in
excess of the 9.25% hurdle rate, because the interest
rate cap effectively removed all incremental
advancing costs due to interest rate increase. As a
result, like a fixed-rate loan, there is no incremental
loss exposure for this loan.
• Scenario 2: The loan defaults at the end of the second
year of the term. The cap prevents incremental
advancing costs during the third year of the loan term
when the loan is being worked out. However, during
the last six months of the workout period the servicer
summer 2000 11
CMBS: Moody’s Approach to Rating Floating Rate Transactions (cont.)
defaults. Furthermore, during the workout period
floating rate bonds may incur higher losses due to poten-
tially higher interest advancing costs. In general, higher
leveraged loans, as indicated by Moody’s LTV ratios,
require more credit enhancement as there is less oppor-
tunity for the equity position to help absorb the interest
payment risk. As leverage becomes very high, the floating
rate credit enhancement adjustment for high-rated
classes tends to level off since all loans are stressed to
default. A longer time horizon also creates additional
uncertainty and increases the possibility of interest rate
increases. Hence, loans with longer terms to maturity,
inclusive of contractual extensions, require more credit
enhancement. Last, but not the least, interest rate caps
during the loan term help offset floating rate risk, but do
not completely eliminate it. Term caps do not generally
provide any protection for interest advancing from rate
volatility during any potential tail period after the loan
maturity date, so loans that default at or near balloon
dates may still be exposed to interest rate risk.
While we believe that Moody’s approach to floating rate
CMBS offers a solid conceptual framework, we do not
have the benefit of a rich set of empirical data to test our
results. This is unfortunately the case for CMBS research
in general. When there are more floating rate loans being
originated and serviced in the future, the assumptions
underlying this approach could be verified or modified.
John Junyu Chen and Milton Chacon are both Vice
President and Senior Analyst at Moody’s Investors
Service. They can reached at chenj@moodys.com or
chaconm@moodys.com.
1
The loan term in this report includes contractual extension periods. The
tail period is defined as the period of time following the maturity date of
the loan during which the servicer is required to resolve any defaults and
liquidate defaulted assets.
2
Other financing alternatives such as short-term fixed-rate debt offered by
some insurance companies are generally not available in the CMBS
market. Other alternatives could emerge as lenders respond to market
needs
3
Fixed-rate loan prepayment protection is typically a combination of
lock-out, yield maintenance and defeasance with a short open period a
few months prior to the maturity date.
4
For example, the increase in the ten-year Treasury rate from 4.7% to 6.3%
in 1999 generated greater interest in floating rate financing by traditional
conduit borrowers.
5
For example, if the in-place leases are below Moody’s assessment of
sustainable market rents, then an upward adjustment to in-place cash flow
might be considered. A myriad of factors, such as the schedule of lease
rollovers and availability of capital for re-tenanting costs, are considered in
arriving at conservative upward adjustments to in-place cash flows. Also
taken into consideration are any plans and capital expenditures to
improve the property. Capital spent for value creation (e.g., upgrading from
Class C to Class B), as opposed to value preservation (e.g. repairing roof
and HVAC) may be considered favorably.
6
For further information on Moody’s approach to subordinate debt, see
CMBS: “Moody’s Approach to A-B Notes and Other Forms of
Subordinate Debt”, February 4, 2000.
7
Recently, we have seen an increasing interest from issuers to deviate from
a pure sequential principal pay structure, with particular emphasis on
diverting a portion of the principal proceeds to the below investment grade
classes. As the timing of repayment becomes more certain, holders of these
classes of bonds are willing to pay more for them, everything else being
equal. From the issuer’s perspective, this results in the receipt of greater
proceeds and thus a more profitable execution.
8
Based on the historical LIBOR distribution, 95% of the time LIBOR
would not increase by more than 600 basis points during a three-year
period or more than 800 basis points during a five-year period. This
spread differential between the five- and the three-year term demonstrates
the potential volatility due to term.
9
For a discussion on various forms of interest rate models, see Chan,
Karolyi, Longstaff and Sanders, “An Empirical Comparison of Alternative
Models of the Short-Term Interest Rate”, in The Journal of Finance,
1992. For the particular purpose of floating rate CMBS rating method-
ology, we applied a simple form of the mean-reverting stochastic process
model (i.e. the Vasicek model specification). The computation follows Dixit
and Pindyck, Investment Under Uncertainty, 1993, Princeton
University Press. Some modifications were made in deriving Moody’s
CMBS stressed interest rate assumptions.
10
The servicer is never required to advance balloon amounts. However,
upon a balloon default, the servicer will continue to advance an assumed
monthly debt service based on the pre-default loan terms. If the floater is
an interest only loan, there is no principal component to the servicer’s
advances. The servicer’s obligations are generally backed by the trustee and
fiscal agent (if one exists), one of which is typically rated at least Aa3.
11
Even though real estate may be considered an inflation hedge in the long
run, the borrower might not be able to increase rents at will due to the
contractual nature of rental agreements and the timing of the rollovers.
Furthermore, the correlation between rents and inflation, and hence
nominal interest rates, can be disrupted by other supply and demand
factors affecting the real estate cycle.
12
In computing the break-even interest rate, we consider that borrowers are
typically motivated to support a property after the cash flow becomes insuf-
ficient to pay the debt service due to temporary interest rate spikes since
there is an option value to hold on to the property. A borrower may use
funds from other sources, postpone management fees, or delay capital
improvements. Furthermore, certain temporary income such as above-
market rents, which are not accounted for in Moody’s net cash flow, may
provide additional liquidity.
13
The empirical research on the correlation between property value and
interest rate is limited. For a diversified conduit pool, the joint probability
is assumed around 0.6 to 0.7 for high-rated classes. For single asset or
large loan pools with less diversity, a higher joint stress probability is typi-
cally assumed.
14
Loans with higher leverage have lower breakeven mortgage interest rates,
and therefore higher interest rate advancing costs and higher loss severity
for interest rate related defaults.
15
Any actual loans may have different terms, spreads or property types
from those assumed in this example, and therefore may have different
credit enhancement adjustments.
summer 2000 13