2017-04-05 10:00:01.0 GMT
By Matt Scully and Adam Tempkin
(Bloomberg) — Only a decade ago, global investors got a
hard lesson about the dangers of relying on rosy bond ratings.
Now they’re getting a reminder — this time in frothy corners of
the $528 billion U.S. commercial-mortgage bond market.
As delinquencies on loans rise, some ratings firms are
walking back their grades on bonds tied to properties like
shopping malls and office towers, just a few years after
assigning them. DBRS Inc. last month lowered the AAA ratings it
had given 294 interest-only bonds after realizing it had been
too lenient. Also in March, Kroll Bond Rating Agency Inc. cut
some of its grades on a $1 billion bond issued in 2014, citing
weakness in Texas loans exposed to energy prices.
The reversals underscore how forces that brought trouble to
financial markets before are still percolating through Wall
Street today. No one sees the dangers as being nearly as grave
as they were during the home mortgage bust. But the same ratings
business model used during that period still prevails — meaning
that the banks that put together debt securities still pay for
the credit grades, and they can shop around for the firm that
will give them the highest ratings under the loosest criteria.
That’s what money managers say started happening a few
years ago in the commercial-mortgage bond market. Around 2013
and 2014, smaller ratings firms including DBRS and Kroll grabbed
business from the long-time triumvirate, S&P Global Ratings,
Moody’s Investors Service and Fitch Ratings. The upstarts,
investors warned at the time, were being too generous in
evaluating commercial-mortgage bonds. One example: banks avoided
Moody’s ratings after the firm demanded that they provide more
cushion against losses in the riskiest CMBS securities, and
instead hired other graders with easier requirements.
For their part, the ratings firms say increased competition
since the 2008 financial crisis has created more checks and
balances on grades, and that the issuer-pay model works. Kroll
and DBRS say their recent ratings cuts are isolated and not
indicative of a wider problem in commercial real estate or with
Investors were already signaling their skepticism with
upstart bond graders even before the recent downgrades. Prices
on bonds they rated from 2014 have dropped over the past two
years, and in general trade at lower valuations relative to
benchmarks than peers, said Dave Goodson, head of securitized
products at Voya Investment Management in Atlanta.
“Ratings shopping’s impact is already clearly manifest in
the market,” Goodson said. While bond graders ought to have
differing views for any deal, it’s problematic if standards end
up broadly dropping, he said. “There can be real consequences
for the market from rating agency competition.” The problem
abated last year in part because of investors’ pushback.
Investors, lawmakers, and others have long complained about
credit rating firms loosening their standards to win business.
The financial crisis was fueled in part by ratings firms making
it easier for residential mortgage bonds to win top grades,
according to the U.S. Financial Crisis Inquiry Commission.
Even after the crisis, the U.S. Securities and Exchange
Commission fined S&P and barred the firm from a major portion of
the commercial-mortgage bond market for a year, saying it
watered down its requirements in 2012 in order to win business,
while masking the changes from investors. Lawmakers and
regulators have taken some steps to overhaul the credit ratings
industry, but haven’t altered how the companies are paid.
“The same credit rating system is still in place,” Al
Franken, a Democratic U.S. Senator who has tried to pass
legislation that would have changed the bond graders’ business
models, said in an emailed statement to Bloomberg. “Unless we
take action those agencies will continue to put the financial
security of Americans at risk.”
DBRS downgraded a series of securities that were mostly
issued between 2014 and 2016, it said. The company changed the
way it rated the instruments, by looking more closely at the
credit quality of the bonds that the interest-only securities
are linked to. The securities had top AAA grades until the cuts,
but the market wasn’t trading these instruments as if they had
top ratings, said Erin Stafford, managing director and head of
North American CMBS ratings at DBRS, said in a phone interview.
The change wasn’t a reflection of the firm’s view of the
strength of the commercial-mortgage bond market post-crisis,
Stafford wrote in an email.
Last month Kroll downgraded riskier portions of a $1
billion offering underwritten by Citigroup Inc. and Goldman
Sachs Group Inc. in 2014. Kroll was the only rating firm
ultimately hired to grade the affected bonds, even after the
banks sought preliminary opinions on the securities from Moody’s
and Fitch, people familiar with the matter said. Those two bond
raters had viewed the debt more conservatively, the people said.
Spokesmen for Citigroup and Goldman declined to comment.
Junk-graded debt is supposed to have volatility in ratings,
said Nitin Bhasin, a managing director in Kroll’s CMBS business,
in response to questions about the rating cuts. “In this
instance, none of the loans have yet defaulted, and we are
trying to be forward looking. The stress in the oil market is
producing this issue.”
The rating firm also devotes more resources to watching
commercial-mortgage bond deals for signs of stress than its
competitors do, and is more proactive about identifying troubled
deals than its competitors, Bhasin said.
As competition has heated up, a wider array of opinions on
credits has emerged. A spokesman for Moody’s Investors Service
said that the firm had stricter standards than many rivals
around 2014. A spokesman for S&P said the company only rates
transactions that meet its criteria, and welcomes free
competition. The fact that issuers pay for ratings allows the
firm to make its grades widely available to the public for free,
which means its opinions are subject to wide market scrutiny.
Kevin Duignan, Fitch’s head of structured finance, said his
firm is confident about its analysis and vocal when its views
differ from other ratings firms’. The result is more robust
transactions, he said.
Even if the securities are more robust, risks have been
building in the property bond market for a while. The
delinquency rate for property loans bundled into bonds reached
5.37 percent in March, and has risen in 11 of the last 13
months, according to property research firm Trepp. A large share
of the securities created after the financial crisis were
stuffed with loans backed by aging shopping malls that have been
increasingly losing shoppers to online retailers, bonds that
some investors are now shorting.
Around 2014 more than a dozen money managers, including
MetLife Inc. and Genworth Financial Inc., started complaining to
the SEC about underwriters easing their standards and creating
riskier debt. For example, banks were packaging bigger loans
relative to property values into the securities.
The investors said that credit graders were enabling the
riskier debt to be sold. New regulations that the SEC adopted to
reduce conflicts in the business had produced “no perceivable
changes in ratings practices post-rule adoption,” according to
emails related to the investors’ meetings and obtained by