Ratings Shopping Revived in Asset-Backed Rebound: Credit Markets
Almost six years after the start of the worst financial crisis since the Great Depression, bond issuers are again exploiting credit ratings by seeking firms that will provide high grades on debt backed by assets from auto loans to office buildings considered inappropriate by rivals.
Fitch Ratings isn’t grading a deal linked to a Manhattan skyscraper after saying investors needed more protection. The securities won top grades from Moody’s Investors Service and Kroll Bond Rating Agency Inc. Blackstone Group LP’s Exeter Finance Corp. got top-tier ratings from Standard & Poor’s and DBRS Ltd. in the past 15 months on $629 million of bonds backed by car loans to people with bad credit histories, even as Moody’s and Fitch said they wouldn’t grant such rankings.
Borrowers are finding more options than ever to get the top ratings that many investors require after U.S. regulators doubled the number of companies sanctioned to assess securities to 10 since 2006. That expansion is facing scrutiny as the Securities and Exchange Commission met today in Washington to discuss Senator Al Franken’s plan to create a board to select which firms grade asset-backed bonds, rather than leaving it to the banks that pay the raters.
“Imagine the pharmaceutical industry having six FDAs, all competing to approve drugs,” said Rob Dobilas, who founded Realpoint LLC, the credit-rating company bought by Morningstar Inc. in 2010, referring to the U.S. Food and Drug Administration. “Everyone would be dead.”
Issuance of bonds linked to loans and leases are staging a comeback as the Federal Reserve (FDTR)’s unprecedented stimulus, including a pledge to keep benchmark interest rates close to zero into a fifth year, pushes investors into riskier assets.
Banks have arranged $31.5 billion of commercial mortgage-backed securities this year with issuance poised to climb 50 percent from 2012 to $70 billion, according to Credit Suisse Group AG. Issuance of bonds tied to subprime auto debt of $7.7 billion this year compares with $5.7 billion in the first four months of 2012, according to Wells Fargo & Co.
Fitch said yesterday in a statement that it was asked not to rate a transaction linked to a $782.8 million loan on the Seagram building at 375 Park Avenue in New York after determining that investor protections were insufficient for top grades.
The mortgage on the tower, designed by Ludwig Mies van der Rohe, allows the borrower to take on higher levels of debt on the assumption that the building will generate more cash in the future. The deal, rated AAA by Moody’s and Kroll, assumes $74 million of income from the property, compared with $54 million as of 2012, according to Fitch.
So-called pro-forma lending was common during the property market boom leading up to a record $232 billion in commercial-mortgage bond sales in 2007, sparking a surge in defaults when properties failed to meet those expectations. The type of underwriting was a “major reason” behind ratings cuts on AAA securities issued from 2005 through 2008, Fitch said in its statement.
“We didn’t give credit to pro-forma rents,” said Eric Thompson, a New York-based analyst at Kroll. The rater used $61.2 million in income to underwrite the loan compared with the issuer’s $73.6 million, according to a May 9 report. “We tried to take into account the property’s performance and the context of its market,” he said.
The Seagram building is a world-class property with the capacity to retain value “well in excess” of the rated debt amount, according to Moody’s analyst Tad Philipp.
“Moody’s new issue and surveillance CMBS ratings address the intrinsic income generating ability of the collateral,” Philipp said in an e-mail. “We do not assume high quality buildings are worth zero when empty or that they are as good as they appear when full.”
Scott Helfman, a spokesman for Citigroup Inc., and Amanda Williams of Deutsche Bank AG, both in New York, the underwriters on the Seagram building deal, declined to comment.
“Nothing’s really changed” in the ratings business, David Jacob, former head of structured finance at S&P, said in a telephone interview. Regulation “changed some of the processes that they do, but what led to a lot to this bad behavior hasn’t really changed.”
Debt graders led by S&P and Moody’s helped ignite the credit seizure that began in August 2007 by lowering their standards to win business before defaults soared on home loans to subprime borrowers, the Federal Crisis Inquiry Commission said in a January 2011 report.
“My plea today is that you take action,” Franken, a Democrat from Minnesota elected to the Senate in 2008, told participants at the SEC roundtable today. “If we maintain the status quo we are leaving ourselves far too vulnerable to another catastrophe.”
The special status of ratings companies in the U.S. financial system dates back to the depths of the Great Depression. In 1936, Office of the Comptroller of the Currency banned banks from holding bonds that were below investment grade, or securities rated under BBB- by S&P and Baa3 at Moody’s.
In 1975, the SEC designated S&P, Moody’s and Fitch as Nationally Recognized Statistical Rating Organizations, or NRSROs, and required some investors to buy only securities stamped with the companies’ creditworthiness opinions.
While Congress responded to the crisis by passing the Dodd-Frank Act in July 2010 to remove some credit-rating references from regulation, reducing the financial industry’s reliance on the grades, lawmakers didn’t address how the companies are paid.
The SEC deferred deciding on whether to set up a board for structured product ratings in a December report submitted to Congress, instead opting to convene today’s roundtable. Ratings for structured products would go through a board composed of a majority of investors if the SEC adopted Franken’s measure. Firms would potentially be chosen on a rotating basis or lottery system.
In February, the Justice Department sued S&P, a unit of New York-based McGraw Hill Financial (MHP), alleging the world’s largest credit rater inflated grades on mortgage-backed securities to win business from Wall Street banks. Calling the case “meritless,” McGraw Hill said in a Feb. 5 statement it will “vigorously defend S&P against these unwarranted claims.”
Debt markets remain dependent on ratings companies, with state and local pension funds relying on opinions to make investments and the Basel Committee on Banking Supervision linking capital requirements to the grades. That’s preserved the tendency of issuers to shop for the most lenient ratings, not those conducting the best analysis, Dobilas, now a managing partner at Orchard Strategic Advisors LLC, an investing and consulting firm, said in a telephone interview.
While S&P, Moody’s and Fitch accounted for 96 percent of all outstanding credit ratings as of the end of 2011, according to a November SEC report, competition is more keen in the securitized market where bonds often carry ratings from at least two firms.
JPMorgan Chase & Co. got AAA ratings on $571 million of home-loan securities from Fitch, DBRS and Kroll even as Moody’s said in a March report that contractual promises about mortgage quality in the bank’s bonds were too weak to allow for the top grades. Hertz Global Holdings Inc. scored Aaa grades in January from Moody’s on rental-car securities that S&P’s methodology shows it would have ranked lower based on Hertz’s own credit assessment.
Fueled by the securitization market, subprime auto loans accounted for 43 percent of car financing in the fourth quarter, the biggest portion since 2007, according to Experian Information Solutions Inc.
Debt from Exeter, a subprime auto lender started in 2006, received ratings as high as AAA from DBRS and AA from S&P in three deals. Moody’s called the grades “inappropriate” in a February 2012 report, saying Exeter was “small and unrated, with limited experience and little asset performance history.”
Meredith Fletcher, a spokeswoman for Exeter, declined to comment.
Fitch doesn’t grant top-tier ratings to subprime-auto issuers lacking lengthy, consistent track records and strong financial health to protect investors from what can go on “behind the scenes” as well as potential collections problems after a bankruptcy, John Bella, a managing director at the credit rater, said in a telephone interview.
Especially “at the AAA level, with the implied lack of volatility that should go on behind those ratings, that’s just not something we’re prepared to do,” Bella said.
DBRS sends out two teams to a new subprime-auto issuer’s offices to examine its operations and loan quality while another group studies the company’s financial health, said Christopher O’Connell, a senior vice president.
While a “limited track record is very difficult to overcome” an issuer can get DBRS’s top ratings if management has a lot of experience, lending systems are robust and the bonds have the appropriate amount of structural protections, O’Connell said.
“Putting a cap on things, we don’t think is the right approach,” he said in a telephone interview. “We know every single bond stands on its own, and we have to look at every one of these bonds critically.”
S&P excludes certain securities from top ratings, and in some cases declines to grade them, because of concerns that their credit performance will be unstable, among other reasons, Ed Sweeney, a spokesman for S&P, wrote in an e-mailed statement.
“S&P takes these actions knowing that some issuers could choose other agencies to rate the securities,” Sweeney wrote.
Elsewhere in credit markets, Dish Network Corp. (DISH), the satellite TV company vying with SoftBank Corp. (9984) to acquire Sprint Nextel Corp. (S), is offering $2.5 billion of debt to help finance the proposed deal. The cost to protect against losses on corporate bonds in the U.S. fell for the first time in five days.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, fell 1.8 basis points to a mid-price of 71.8 basis points as of 12:38 p.m. in New York, according to prices compiled by Bloomberg.
In London, the Markit iTraxx Europe Index, tied to 125 companies with investment-grade ratings, was little changed at 96.3. The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell 0.15 basis point to 14.1 basis points. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Petroleo Brasileiro SA are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 11.7 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Petrobras, as the Brazilian state-run oil producer is known, sold $11 billion of bonds abroad yesterday, the most ever for an emerging-market issuer. The company’s $3.5 billion of 4.375 percent notes due in 2023 rose 1.56 cents from the issue price to 100.39 cents on the dollar to yield 4.33 percent at 12:34 p.m. in New York, Trace data show.
Dish may sell four- and 10-year bonds today or tomorrow, according to a person familiar with the transaction. The proceeds from the senior notes sale will be placed into escrow and would be released to help fund the cash portion of a Sprint acquisition, the Englewood, Colorado-based company said today in a regulatory filing. Dish will redeem the debt if a deal doesn’t materialize, it said.
The offering comes a month after SoftBank sold $3.3 billion of bonds denominated in dollars and euros to help fund its $20.1 billion bid for Sprint, Bloomberg data show.
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