(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.
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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."
