“If we don’t give them the ratings they’ll go to Moody’s right down the block. If we don’t work with them, they will go to our competitors. Not our fault, simply the way the world works.” – from ‘The Big Short’.
Rating agencies are back inflating asset ratings like it’s the early 2000s. Hindsight apparently isn’t 20/20. Even following the devastating economic impacts of the 2007 recession – where rating inflation played a central role in the MBS derivatives collapse – the lack of intervention to regulate the financial sector has enabled this malpractice to continue.
Why? Because following the crisis Congress continued to allow asset issuers (i.e. investment banks) to pay to have their assets rated, thus maintaining their leverage over deciding which rating agency to choose. As expected, the banks issuing these securities want the best ratings possible because an investment grade AAA rated security means lower interest payouts to investors (Figure 1, Investopedia, 2019), resulting in greater profitability for the banks. Subsequently, this creates a competitive market where rating agencies are incentivized to undercut one another, lowering ratings standards in attempt to attract business and grow market share.
Where these inflated asset ratings are most prevalent, according to a WSJ report, is in structured finance (Banerji, C., 2019). This is where investment banks take tranches of student loans, auto loans, housing mortgages etc. to produce securities called collateralized debt obligations which are sold on to institutional investors who are paid out at intervals on a percentage basis. What determines these percentage payouts is the risk level of the asset (higher risk = higher yield = higher percentage) and this is classified by rating agencies such as Standard & Poor’s, Moody’s, Fitch Group to name a few.
According to the SEC fees for rating structured finance deals can exceed $1 million so we can see where the incentive is for inflating asset ratings. In 2015, Standard & Poor’s was fined $1.5 billion for inflating mortgage backed securities in the leadup to the 2007 recession; Moody’s was forced to pay out $684 million (Investopedia, 2019). However, even following the crisis Standard & Poor’s was fined $58 million by the SEC for intentional fraud in 2012 (Sec.gov, 2019). The continued rating inflation, despite the extraordinary fines, shows how profitable this practice must be and how truly unregulated it is.
One specific subdivision of structured finance showing prominent signs of rating inflation is commercial mortgage-backed securities (CMBS), a $1.2 trillion market which funds deals for malls, hotels etc. The Journal found that Dominion Bond Rating Service (DBRS) rated CMBS bonds higher than Standard & Poor’s, Moody’s and Fitch (the Big 3 rating agencies) 39%, 21% and 30% of time, respectively. Morningstar rated the bonds higher than the Big 3 at least 36% of the time. This can potentially be the difference between junk bonds and AAA. Notice how even more so it is the smaller rating firms who are aggressively inflating asset ratings. As previously mentioned, this is how smaller firms can vie for market share growth in an oligopolized market (Figure 2, Ft.com, 2019).
Examples
BACM 2005-1, a Class B CMBS issued in 2005. It initially contained 140 mortgages but as these mortgages were paid off over time the debt pool shrank. Now 97% of the bond is backed by Stonecrest’s Atlanta Mall mortgage payments, according to commercial mortgage tracker Trepp LLC. However, Stonecrest suffered great financial difficulty; it’s Kohl’s closed in 2016, Sears in 2018, and ShoeSource finished its going-out-of-business sale this May. In 2018 when its $90.5 million mortgage was due, the mall owners defaulted. Standard & Poor’s downgraded the bond 3 times, but despite the default the CMBS is still labelled as investment grade – indicating no risk of financial loss. Even Stonecrest’s Mayor Jason Lary gave the mall a “50-50 chance of survival.”
Microsoft’s $26 billion purchase of LinkedIn Corp. in 2016. Standard & Poor’s awarded it a AAA rating. It cited Microsoft’s “long history of making investment decisions in a fiscally prudent manner” despite the fact that Microsoft had written down its $9.5 billion acquisition of Nokia Corp. in 2014 where it cut almost 10,000 jobs from the Nokia division through 2016 and destroyed an entire mobile platform (Ft.com, 2019).
In conclusion, rating agencies inflated the asset/derivatives markets leading up to the 2007 crisis, little was done to amend the foundations of our financial regulatory structure in the aftermath, and thus we find ourselves in the same predicament, the same fraudulent malpractice, like nothing ever happened.
Second year economics undergraduate at the UCL.
