Ratings shopping never died in CMBS market now facing crisis

It was considered one of the root causes of the global financial crisis, and regulators have spent over a decade trying to stamp the practice out. Yet Kroll Bond Rating Agency Inc.’s $2 million fine last week shows how in the securitized-debt market, the battle against ratings shopping was never truly won.

Kroll settled with the U.S. Securities and Exchange Commission over its failure to adhere to credit-rating standards for commercial-mortgage bonds and collateralized loan obligations, just months after rival Morningstar Credit Ratings LLC (DBRS Morningstar) was hit with an even larger penalty by the regulator.

The recent fines are fueling concerns that rosy credit grades are masking deeper structural problems with the securities. The risks are particularly acute in the CMBS market, where shutdowns stemming from the coronavirus pandemic have battered revenues for malls, hotels and other commercial properties that back the debt, spurring a raft of downgrades.

“The issue of ratings-shopping and grade inflation is still unresolved,” said Jeffrey Manns, a law professor at George Washington University. “This example from Kroll shows that rating agencies may still be under pressure to tweak their methodologies to get business. In good times, these problems don’t matter very much, but in bad times, these intrinsic problems become more salient.”

The practice of ratings shopping, where debt issuers seek credit graders they believe will give them the highest grades, stems from the fact that ratings firms are paid by the companies selling the securities.

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Since the financial crisis, commercial mortgage backed securities have been designed to be safer than they were before, including having less debt relative to assets. Underwriters now also don’t assume that properties will have a high level of income for their whole lives, and instead base their forecasts on current cash flows.

But according to the SEC, Kroll permitted its CMBS analysts to adjust their assumptions for how much a building’s revenue would decline if it defaulted on a loan, because for example, tenants might be less willing to renew their leases in that scenario. The adjustments had material effects on the final ratings of bond deals, but did not require any analytical method for determining when and how those adjustments should be made, the SEC said in a statement Tuesday.

Further, the regulator charged that there was no requirement at Kroll to record the rationale for those adjustments.

Morningstar’s $3.5 million fine was related to its using asset-backed ratings analysts to help market the firm’s services, a violation of conflict-of-interest rules, according to the SEC. Both Kroll and Morningstar have said that they stand by the integrity of their ratings, and neither admitted nor denied the SEC’s findings.

The issue of ratings shopping has historically been most problematic in the market for securitized debt, where the structures of the securities depend heavily on ratings firms’ individual models, and the graders with the most lenient models can win more business as long as their ratings remain credible.

Prior to the 2008 financial crisis, credit-rating firms engaged in a “race to the bottom,” easing their grading standards for mortgage-backed securities and collateralized debt obligations to avoid losing market share, the U.S. Senate’s Permanent Subcommittee on Investigations wrote in a 2011 report.

Despite attempts by regulators in subsequent years to hold the industry to account, the problem has persisted.

Around 2014, as smaller upstarts such as Kroll and Morningstar were grabbing market share from larger rivals, some of the biggest CMBS buyers started complaining to the SEC that the shift was resulting in riskier deals getting higher ratings, and asked regulators to intervene.

Even the bigger ratings firms have faced scrutiny. The SEC fined S&P and barred the firm from a major part of the CMBS market for a year in 2015, saying that it watered down its requirements three years earlier to win business without telling investors.

“It would not be surprising if an economic downturn such as the current one exposes the structural problems of securitization ratings, and that this becomes a focal point,” said George Washington University’s Manns.

The overall CMBS delinquency rate spiked to 10.3% in June from 2.3% in April, the highest level since 2012, according to data from industry tracker Trepp. The most recent report for August saw delinquencies at around 9%.

“The ratings system is broken, unfortunately,” said Marc Joffe, a senior policy analyst at Reason Foundation, a libertarian think tank, and a former employee of Moody’s Analytics and contractor for Kroll. “While this recession may not be as deep as the last one, there are some similarities. Last time, there was a housing bubble. This time, there was a commercial-property bubble. It just takes one thing to pop it, and this time around, it was Covid.”