Every time Standard & Poor’s (S&P) clarifies its approach to commercial mortgage-backed securities (CMBS), the marketplace grows a little more confused.

In late May, when S&P announced its intention to toughen up its methodology for evaluating CMBS, it dealt a blow to an industry already struggling to get off the mat. In one day, spreads on AAA-rated, 10-year CMBS instantly soared toward 800 basis points (bps) from 550 bps.

On July 14, S&P made good on its promise, downgrading billions of dollars in CMBS issued by Credit Suisse, Wachovia, and Morgan Stanley, among others. But just a week later, S&P did a dramatic about-face, saying it would upgrade many of the bonds it initially downgraded, which only spread more confusion throughout the market.

“S&P screwed up, and it’s created more uncertainty,” says David Cardwell, vice president of capital markets at the Washington, D.C.-based National Multi Housing Council. “This is a very reactive market that’s still trying to respond to a number of variables that are changing on a very frequent basis.”

Flip Flopping
S&P says it was inundated with client calls regarding the new methodology and realized that its new approach was unnecessarily stringent, specifically regarding shorter-term bonds. The company initially applied the same model to long- and short-term bonds but realized that many short-term bonds should maintain AAA status since they would mature much sooner, making them less risky.

Had S&P decided to only apply its new methodology to newly issued CMBS, there might not have been such a strong backlash from the investor and issuer community. But S&P retroactively applied the new standard.

“The better way to do it would be to start the new structure going forward, from here on in,” says Dan Fasulo, managing director at New York-based market research firm Real Capital Analytics. “The industry would’ve accepted that. But to basically tear apart people’s portfolios and redo the whole system didn’t make much sense.”

Federal Pressures
S&P’s new methodology also undercuts the government’s TALF program, since only AAA-rated securities were eligible for financing under the initiative. As a result, industry watchers speculate that the government likely put pressure on S&P so that a greater pool of legacy CMBS would be available for TALF. 

“S&P probably won’t admit how much of their current about-face is associated with pressure from the Treasury or the Fed, but it would seem there’s a case to be made there,” Cardwell says.

Coincidentally, S&P’s reversal came the very same day that the Obama administration proposed new regulatory changes regarding ratings agencies. Specifically, the Treasury Department proposed forming a separate SEC office to oversee ratings agencies and banning ratings agencies from doing consulting work with the issuers they rate.

Many believe the new regulations are overdue, as they would do away with any appearance of a conflict-of-interest between the raters and the rated. “They were making judgments on bond issues after getting paid by the issuer,” Fasulo says. “Think about that for a second.”

Despite all the noise, the CMBS industry is still casting a hopeful eye to the TALF program as a starting point for the market’s recovery. Newly issued CMBS is expected to go through the TALF pipeline in the next month or so, mostly single-borrower issuances from large office and retail REITs.

In the meantime, various industry efforts are underway to convince the government that the TALF program needs to be extended for it to have a meaningful effect. TALF is currently set to expire at the end of the year. On July 31, Rep. Paul Kanjorski (D-Pa.) and Rep. Gary Miller (R-Calif.) called on the Treasury to extend TALF through the end of 2010 in a letter signed by several dozen members of Congress.