By Cezary Podkul and Gunjan Banerji
Times are tough for the Mall at Stonecrest in suburban Atlanta. The Kohl's closed in 2016. The Sears shut in 2018, and the Payless ShoeSource finished its going-out-of-business sale in May. When a $90.5 million mortgage came due last summer, the mall's owners defaulted.
Through it all, S&P Global Inc. has said a security tied to the mall's mortgage wouldn't lose money. S&P says the "situation is fluid" and "we won't hesitate to revisit the rating."
Inflated bond ratings were one cause of the financial crisis. A decade later, there is evidence they persist. In the hottest parts of the booming bond market, S&P and its competitors are giving increasingly optimistic ratings as they fight for market share.
All six main ratings firms have since 2012 changed some criteria for judging the riskiness of bonds in ways that were followed by jumps in market share, at least temporarily, a Wall Street Journal examination found. These firms compete with one another to rate the debt of borrowers, who pay for the ratings and have an incentive to pick rosier ones.
There are signs some investors are skeptical. Some bonds in markets where ratings criteria have been eased don't trade at the high bond prices their ratings suggest they should. Investors have also shown skepticism about ratings on some corporate and government bonds.
"We don't trust the ratings," says Greg Michaud, director of real estate at Voya Investment Management, which holds $21 billion in commercial-real-estate debt.
The problem is particularly acute in the fast-growing market for "structured" debt -- securities using pools of loans such as commercial and residential mortgages, student loans and other borrowings. The deals are carved into different slices, or "tranches," each with varying risks and returns, which means rating firms are crucial to their creation.
The Journal analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019. The data, compiled by deal-tracker Finsight.com, allowed a direct comparison of grades issued by six firms: majors S&P, Moody's Corp. and Fitch Ratings, and three smaller firms that have challenged them since the financial crisis, DBRS Inc., Kroll Bond Rating Agency Inc. and Morningstar Inc.
The Journal's analysis suggests a key regulatory remedy to improve rating quality -- promoting competition -- has backfired. The challengers tended to rate bonds higher than the major firms. Across most structured-finance segments, DBRS, Kroll and Morningstar were more likely to give higher grades than Moody's, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.
"The victims are the investors," says Marshall Glick, a portfolio manager at investment firm AllianceBernstein LP. He was among a group of professional investors who in 2015 complained about inflated ratings to the Securities and Exchange Commission and asked the agency to make it harder for issuers to cherry-pick the best ones, internal SEC memos show.
The SEC didn't implement their recommendations, multiple meeting participants say. Jessica Kane, director of the agency's credit-rating division, declined to comment on the investors' concerns, saying through a spokeswoman: "We encourage anyone with comments, recommendations or concerns to reach out to us."
Rating firms say they don't let business influence ratings. "Just having a higher or lower rating on a deal doesn't make you more or less aggressive. It just either makes you wrong or right in the long run," says Kunal Kapoor, chief executive officer of Morningstar, which acquired DBRS last month. "I stand behind our methodology."
Moody's says "the regular adjustments we make to our models, methodologies and assumptions reflect evolving market conditions." Fitch says "we are focused solely on getting the credit right." S&P says "we compete on analytical excellence" and "no ratings business model is immune from potential conflicts of interest." Kroll says that since its 2011 market entrance, "we have forced incumbent agencies to do better research and reexamine underserved sectors that they previously overlooked."
After the financial crisis, ratings firms were criticized for taking lucrative fees and giving high grades to risky securities that caused big losses for investors. S&P paid $1.5 billion to resolve crisis-era litigation, admitting it set out to change rating models to benefit market share but not admitting wrongdoing. Moody's settled for $864 million without admitting wrongdoing.
Investor reliance on credit ratings has gone from "high to higher," says Swedish economist Bo Becker, who co-wrote a study finding that in the $4.4 trillion U.S. bond-mutual-fund industry, 94% of rules governing investments made direct or indirect references to ratings in 2017, versus 90% in 2010.
Strong bond issuance and a rebound in the lucrative structured-securities market have brought good times back to the rating industry. SEC disclosures show fees for rating structured deals can top $1 million. Industry revenue rose 20% to $7.1 billion in 2017 from 2016, the most recent SEC data show. S&P's and Moody's shares are up more than eightfold in the past decade, and their stocks hit all-time highs last week.
Two fast-growing structured-bond sectors are commercial mortgage-backed securities, or CMBS, and collateralized loan obligations, or CLOs. CMBS fund deals for hotels, shopping malls and the like. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts.
In a May speech, Federal Reserve Chairman Jerome Powell compared CLOs to precrisis mortgage-backed debt : "Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards."
Behind the ratings inflation is a long-acknowledged flaw Washington didn't fix: Entities that issue bonds -- state and local governments, hotel and mall financiers, companies -- also pay for their ratings. Issuers have incentive to hire the most lenient rating firm, because interest payments are lower on higher-rated bonds. Increased competition lets issuers more easily shop around for the best outcome.
The Four Seasons Resort Maui at Wailea, owned by billionaire Michael Dell and featuring oceanfront suites that can go for $14,500 a night, borrowed more and won higher ratings. In 2014, the hotel's investment bankers hired Morningstar to rate a $350 million bond sale backed by the property's mortgage. Morningstar gave ratings to six slices of the debt that ranged from triple-A, expected to withstand the Great Depression, down 14 rungs to single-B, susceptible to losses in a mild recession.
When the resort refinanced its debt in 2017 in a $469 million deal, bankers picked DBRS as one of two firms to rate the debt. DBRS had just loosened its standards for such "single-asset" commercial-mortgage deals. DBRS issued grades as much as three rungs higher on comparable slices rated by Morningstar in 2014.
DBRS's market share doubled to 26% within months of the change, according to industry publication Commercial Mortgage Alert.
Morningstar in June 2018 revamped its methodology for these deals, and its market share swiftly rebounded. It was one of two firms the Maui hotel's bankers picked to rate its next offering, a 2019 deal for $650 million. While the hotel's income had grown since 2014, the debt increase meant various slices of the offering had less cash available to repay investors than in 2014. Morningstar issued grades as much as two rungs higher on comparable slices rated by DBRS in 2017.
That should have lowered borrowing costs. Instead, investors demanded yields above where Goldman Sachs Group Inc. and Barclays PLC investment bankers had initially hoped to sell the debt, say people familiar with the pricing.
DBRS referred inquiries to Morningstar, which says its Maui ratings partly reflected improvements at the resort and that the two firm's methodology changes were meant to provide "greater transparency" to investors. A spokesman from Mr. Dell's investment office referred queries to Goldman and Barclays.
Goldman referred reporters to a bond-offering document, pointing out disclosures saying bankers solicited "preliminary feedback" from six rating firms and hired two based on the size of their triple-A slices.
Another section of the document, which Goldman didn't point out, warned investors they shouldn't rely on ratings because "the recent credit crisis" showed their grades "were not, in all cases, correct."
Rating analysts say their firms have lost deals because they wouldn't provide the desired ratings. "I suppose that's the flip side, isn't it, of having more competition among rating agencies?" Huxley Somerville, a senior Fitch Ratings analyst, said in June after Fitch lost to another agency on rating a mall deal.
'Incentives are wrong'
In the first half of 2015, S&P's share of ratings in the $600 billion CLO market hit a five-year low, at 36%, according to data from industry publication Asset-Backed Alert, an affiliate of Commercial Mortgage Alert. That fall, S&P changed its methodology to make it easier for CLOs to get higher ratings. S&P rated 43% of debt in that market in the second half of 2015. In 2018, its market share hit 48%, still trailing Moody's and Fitch. (Bonds can get more than one rating, so market share can total over 100%.)
When S&P again proposed loosening its criteria this year, a group representing more than 100 professional bond investors wrote a letter to the company, reviewed by the Journal, saying the changes "will lead to a weakening of credit protection for investors at a time where we need it most."
S&P proceeded. It says the changes "take into account the evolution of the CLO market over the past decade."
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