Photographer: Scott Eells/Bloomberg

Crisis-Era Lesson on Lofty Ratings Returns in Property Bonds

  • Investors warned in 2014 of looser criteria on CMBS grades
  • Some credit firms now lowering their ratings on property bonds

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.

Grabbing Business

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 their criteria. Kroll also said it is more proactive about identifying troubled deals than competitors.

‘Real Consequences’

Investors were already signaling their skepticism with grades from upstart firms 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 major ratings firms -- led by Moody’s, S&P and Fitch -- making it easier for residential mortgage bonds to win top grades, according to the U.S. Financial Crisis Inquiry Commission. 

No Change

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, including removing some credit-rating references from regulation, 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, 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.

Ratings Volatility

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. 

Fitch did rate portions of the deal that Moody’s did not. Spokesmen for Citigroup and Goldman declined to comment. 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.” Kroll had rated the two slices of debt BB- and B, or three and five steps below investment grade, respectively. It downgraded both portions one level.

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.

‘Increasingly Vocal’

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 Bloomberg.

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