Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back.

Old_Joe

Following are selected excerpts from a current lengthy and very detailed Wall Street Journal article. They have been significantly edited in the interest of brevity: a read of the entire WSJ article is suggested.

Inflated bond ratings were one cause of the financial crisis. A decade later, there is evidence they persist. In the hottest parts of the booming bond market, S&P and its competitors are giving increasingly optimistic ratings as they fight for market share.

All six main ratings firms have since 2012 changed some criteria for judging the riskiness of bonds in ways that were followed by jumps in market share, at least temporarily, a Wall Street Journal examination found. These firms compete with one another to rate the debt of borrowers, who pay for the ratings and have an incentive to pick rosier ones.

There are signs some investors are skeptical. Some bonds in markets where ratings criteria have been eased don’t trade at the high bond prices their ratings suggest they should. Investors have also shown skepticism about ratings on some corporate and government bonds.

“We don’t trust the ratings,” says Greg Michaud, director of real estate at Voya Investment Management, which holds $21 billion in commercial-real-estate debt.

The problem is particularly acute in the fast-growing market for “structured” debt—securities using pools of loans such as commercial and residential mortgages, student loans and other borrowings. The deals are carved into different slices, or “tranches,” each with varying risks and returns, which means rating firms are crucial to their creation.

The Journal analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019. The Journal’s analysis suggests a key regulatory remedy to improve rating quality—promoting competition—has backfired. DBRS, Kroll and Morningstar were more likely to give higher grades than Moody’s, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.

Two fast-growing structured-bond sectors are commercial mortgage-backed securities, or CMBS, and collateralized loan obligations, or CLOs. CMBS fund deals for hotels, shopping malls and the like. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts.

In a May speech, Federal Reserve Chairman Jerome Powell compared CLOs to precrisis mortgage-backed debt: “Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards.”

Behind the ratings inflation is a long-acknowledged flaw Washington didn’t fix: Entities that issue bonds—state and local governments, hotel and mall financiers, companies—also pay for their ratings. Issuers have incentive to hire the most lenient rating firm, because interest payments are lower on higher-rated bonds. Increased competition lets issuers more easily shop around for the best outcome.

Rating analysts say their firms have lost deals because they wouldn’t provide the desired ratings.

In the first half of 2015, S&P’s share of ratings in the $600 billion CLO market hit a five-year low. That fall S&P changed its methodology to make it easier for CLOs to get higher ratings. When S&P again proposed loosening its criteria this year, a group representing more than 100 professional bond investors wrote a letter to the company, reviewed by the Journal, saying the changes “will lead to a weakening of credit protection for investors at a time where we need it most.” S&P proceeded.

Moody’s ratings on riskier slices of these multi-borrower deals often weren’t as favorable as those of its competitors. By 2015, issuers “essentially stopped soliciting our ratings” on those slices, according to a January commentary from the company. In October 2015, Moody’s eased its rating methodology for single-asset CMBS deals.

In 2016 Fitch [gave] itself wider latitude to use easier rating assumptions.

Investors say ratings inflation is most evident in commercial-mortgage-backed securities, or CMBS, of which investors hold about $1.2 trillion. When rating a security higher than their three big competitors, Morningstar, Kroll and DBRS were around two rungs more generous, on average. Some ratings were a dozen or more rungs higher, potentially the difference between junk bonds and triple-A.

A group of professional investors in 2015 complained about inflated ratings to the Securities and Exchange Commission. Adam Hayden, who manages a $13 billion securities portfolio at New York Life Insurance Co.’s real-estate-investment arm, was among the investors who met with the SEC. He said inflated ratings were a risk to market stability, according to a meeting memo obtained by the Journal.

The SEC didn’t implement their recommendations.

Note: All bold emphasis was added.

LewisBraham

LewisBraham

I have to say it's absurd but totally expected that this is happening again. The incentives for ratings agencies are stupid and full of conflicts of interest. Almost every bubble historically has involved increasing amounts of some form of newfangled debt that eventually someone has difficulty paying and then the crash comes. It is a fundamental flaw in capitalism that has existed from the beginning. Leverage is at the root of most boom-bust cycles.

Crash

+1

Gary

But it's pigs with different colors of lip stick all friggin over again.

rforno

Time to go watch 'The Big short' again......

Anna

From a make it up as you go 10 year old

There's a four leaf clover in those woods over there
It will bring you good luck for your life
But that four leaf clover in those woods over there
Can't be yours 'cause it's already mine.

There's a big pot of gold at the end of the rainbow
It will give you wealth beyond your dreams
But that big pot of gold at the end of the rainbow
Can't be yours 'cause it's already mine.

There's a lot of good things still left for you to find
They will give you good luck for your days
For a lot of good things are left for you to find
But you'd better go before they lock the gate. pop goes the wealthsel.

AndyJ

From OJ's WSJ excerpt(s): "The problem is particularly acute in the fast-growing market for “structured” debt—securities using pools of loans such as commercial and residential mortgages, student loans and other borrowings."

CLOs etc. seem to be the main target of the article, but there's also a brief mention of corp (and gov't) debt. I've been wondering about corp issues ever since learning of the recent, huge slugs of corp debt that's been given BBB ratings, now amounting to ~ 50% of that market. How much of it was rated on the rosy side and is in reality just plain corporate junk?

Old_Joe

@AndyJ: Yes, sir- that's a really good question, isn't it? The way things seem to be heading it looks like we'll have to wait until the next downturn/panic to see reality in ratings. Yet again.