CMBS Subordination, Ratings Inflation and Regulatory-Capital Arbitrage

Using detailed origination and performance data on a comprehensive sample of commercial mortgage-backed security (CMBS) deals, along with their underlying loans 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 below AA upgraded to AA or AAA significantly faster than comparable RMBS (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 over this 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 would have been no losses to the senior bonds in most CMBS structures.