DBRS Downgrades Remaining Swap Rating for Deco 8 – UK Conduit 2 Plc

DBRS Ratings Limited (DBRS) has today downgraded the rating of the potential interest rate swap (IRS) termination amount that may be owed by the commercial mortgage-backed securities (CMBS) issuer to Deutsche Bank AG (Deutsche Bank or the Swap Counterparty) in relation to the Deco 8 – UK Conduit 2 P.L.C. (the Transaction or Deco 8) as follows:

-- Potential Interest Rate Swap Termination Payment - Swap ref 1475920L (initial GBP 71.6 million notional, referencing the Fairhold loan) (the Fairhold Swap) downgraded to B (low) (sf), Negative trend from BB (low) (sf), Negative trend.

The downgrade of the Fairhold Swap reflects the increasing default risk of the Transaction caused by the limited workout progress of the Fairhold and the other securitised loans. Specifically, the likelihood of class A2 to default at maturity, which is one year away, has increased given the current special serviced loans’ workout progress. Upon the occurrence of a note event of default (EOD) and a note acceleration notice, the payment priorty would switch to post-enforcement priority of payment, in which the Fairhold Swap will rank pro rata and pari passu with class A2 principle and interests. This could result in a swap EOD and likely incur an ultimate loss to the swap counterparty.

The Fairhold Swap is set to expire in 2036 and is estimated to have GBP 8 million mark-to-market (MTM) value for the swap Counterparty on April 2018. Its referenced Fairhold loan has one senior and one junior piece and was originated to refinance a portfolio of residential ground leases. The cut-off balance of the senior Fairhold loan on 19 October 2005 was GBP 72 million secured by 92,464 ground leases; however, in 2013, the loan did not repay at maturity and was transferred to special servicing. The balance of the senior tranche in October 2013 was GBP 63 million secured by 82,975 ground leases and the current balance is GBP 56 million backed by 82,170 ground leases per DBRS’s calculations. There have been very limited ground lease disposals since 2013 and the current whole loan’s loan to value (LTV) is over 100%. Nevertheless, given its relative low MTM, its senior ranking at loan level and its shortening time to maturity over time, the Fairhold Swap would likely be repaid in full as long as the Fairhold loan works out.

Regarding the Mapeley II loan, the special servicer had informed the market that the refinancing of the loan was close to completion in May 2016. However, following U.K.’s EU referendum vote, the interested lenders have put the refinancing proposal on hold. Currently the special servicer is still committed to pursuing its strategy of refinancing or selling the portfolio on completion of the remaining asset management initiatives, which will maximise value and recoveries under the loan. A value estimation was also established by the special servicer following the referendum and a broker has given a gross value opinion in the range of GBP 176–184 million. Per RIS Notification published on 30 December 2016, the special servicer has expressed that they can accept a valuation as low as GBP 167.2 million during the Second Additional Standstill Date until 20 January 2018. The current balance for Mapeley II loan is GBP 189 million.

On the note level, the outstanding balance of class A2 as of January 2017 was GBP 235.5 million with an additional liquidity facility drawing of GBP 1.7 million. The current recoverable value, which is the lower of the market value (MV) or the loan balance of all securitised loans is GBP 234.8 million. Therefore, even if all the loans were to be disposed in the next 12 months at the lower of the respective loan balance and market value, there would be a deficiency of GBP 2.4 million (excluding the Fairhold Swap MTM and senior issuer costs) for the issuer to avoid a principal shortfall on class A2.

DBRS believes that it is still possible to work out the Fairhold loan before April 2018. DBRS also notes that the Swap Counterparty has an incentive to facilitate a loan workout before April 2018. However, to reflect the increased risk of a tighter workout deadline since last review, DBRS has today downgraded the Fairhold Swap to B (low) (sf) and kept a Negative trend. The Negative trend reflects that over time the risk of the swap’s defaulting at or shortly after April 2018 will increase.

The IRS in the CMBS are issuer-level swaps that provide for a fixed-rate payment to Deutsche Bank in exchange for a floating-rate (LIBOR) payment by Deutsche Bank to the bond. The swaps were intended to protect the individual loans and the capital structure in the CMBS against rises in interest rates. As part of its rating analysis, DBRS considers the adequacy of the collateral backing the respective loan and the CMBS to cover the swap termination payments, the performance of the collateral and the quality of the legal and financial structure. When rating swap termination payments, DBRS is assessing the ability of the securities to make the swap termination payments to the counterparty by the legal final maturity date of the transaction. DBRS also takes into account the position of swap payment in the pre- and post-enforcement priorities of payment. DBRS uses its European CMBS Rating and Surveillance Methodology to assess the recoverability of the value of the swap termination fees to determine if there is sufficient coverage to make these termination payments by the legal final maturity of the CMBS. To calculate the swap termination payments, DBRS first derives the net swap cash flow for each period by comparing (1) the fixed stream of payments from the notes to the swap counterparty against (2) the LIBOR payments that the counterparty would expect to pay to the notes. Next, DBRS aggregates the net swap cash flow for all future periods to derive the total potential swap termination payments. A rating is only assigned when, under such rating scenario, there is sufficient coverage of collateral to ultimately pay the swap termination payments should the notes default on swap payment obligations on any distribution date. The rating does not address (1) the likelihood that a swap termination event occurs on or before the swap termination date, (2) the payment of any swap termination payment owed by Deutsche Bank to the bond and (3) termination payments owed by the bond to Deutsche Bank if it is the defaulting party.

Notes:
All figures are in British pounds unless otherwise noted.

The principal methodology applicable to the rating is: “European CMBS Rating and Surveillance Methodology”.

DBRS has applied the principal methodology consistently and conducted a review of the transaction in accordance with the surveillance section of the principal methodology.

A review of the transaction legal documents was not conducted as the legal documents have remained unchanged since the most recent rating action.

Other methodologies referenced in this transaction are listed at the end of this press release.

These may be found on www.dbrs.com at: http://www.dbrs.com/about/methodologies

For a more detailed discussion of the sovereign risk impact on Structured Finance ratings, please refer to DBRS commentary “The Effect of Sovereign Risk on Securitisations in the Euro Area” on: http://www.dbrs.com/industries/bucket/id/10036/name/commentaries/

The sources of data and information used for this rating include Deutsche Bank AG, London Branch, Situs Asset Management Limited and Solutus Advisors Limited.

DBRS did not rely upon third-party due diligence in order to conduct its analysis.

At the time of the initial rating DBRS was not supplied with third-party assessments. However, this did not impact the rating analysis.

DBRS considers the data and information available to it for the purposes of providing this rating to be of satisfactory quality.

DBRS does not audit or independently verify the data or information it receives in connection with the rating process.

The last rating action on this transaction took place on 14 June 2016, when DBRS downgraded the Potential Interest Rate Swap Termination Payment - Swap ref 1475920L to BB (low) (sf) with Negative trend from A (sf) with Stable trend.

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.

To assess the impact of changing the transaction parameters on the rating, DBRS considered the following stress scenarios, as compared to the parameters used to determine the rating (the “Base Case”):

Swap ref 1475920L Sensitivity:
-- 10% decrease in DBRS NCF: B (low) (sf)
-- 20% decrease in DBRS NCF: B (low) (sf)

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS’s outlooks and ratings are monitored.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Surveillance Analyst: Rick Shi, Senior Financial Analyst
Rating Committee Chair: Christian Aufsatz, Managing Director
Initial Rating Date: 30 June 2014

DBRS Ratings Limited
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Registered in England and Wales: No. 7139960

The rating methodologies used in the analysis of this transaction can be found at: http://www.dbrs.com/about/methodologies

-- European CMBS Rating and Surveillance Methodology
-- Legal Criteria for European Structured Finance Transactions
-- Derivative Criteria for European Structured Finance Transactions
-- Unified Interest Rate Model for European Securitisations

A description of how DBRS analyses structured finance transactions and how the methodologies are collectively applied can be found at: http://www.dbrs.com/research/278375