After the carnage of the 2008 financial crisis was over, a lot of finger-pointing among the major Wall Street players ensued in an attempt to assign blame for a catastrophe that few saw coming. One of the prime targets in the fiasco were the staid bond rating firms: Standard & Poor’s, Moody’s, Fitch and a few lesser-known entities. The opprobrium directed at their lax standards for assessing credit risk was well deserved.
In hindsight, it was apparent that the high credit ratings assigned by these bond analysis firms to some of the securitized tranches of home mortgages grossly understated or ignored the risks associated with these novel debt obligations. The investors who relied on these ratings as a basis for purchasing these instruments suffered great losses and the reputations of the reporting agencies were tarnished.
Recently, the ghost of credulous default risk ratings has reared its head once again. In a quest to enhance market share, many firms are issuing ratings that minimize the risks to investors who purchase the debt instruments of various corporate issuers.
This baneful ratings process is reminiscent of the scandalous conflict of interest problems that plagued the accounting industry over 15 years ago, which caused the dissolution of Big Eight accounting firm Arthur Andersen and led to the enactment of the Sarbanes-Oxley Act.
Even though the credit ratings themselves may be suspect, many investors continue to rely on the risk assessment assigned by these firms. Federal Reserve Chairman Jerome Powell has, on numerous occasions, made no secret of his concern about high corporate debt levels and unreasonably high credit ratings.
During a May 2019 speech, Powell likened one of the hottest debt instruments today, collateralized loan obligations, to pre-2008 crisis mortgage-backed debt. As Powell noted, “Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards.”
What regulators failed to address post-2008 was the inherent conflict of interest in the corporate credit review process, where issuers also pay for the ratings. This is like putting the fox in charge of the henhouse. This endemic structural flaw is eerily reminiscent of the questionable reliability of the financial statement certifications major accounting firms gave house-of-card companies such as Enron, which resulted in enormous investor losses.
Accounting firm shopping was common by corporations at that time. Firms such as Arthur Anderson had long-term lucrative IT consulting contracts with the same companies whose financial statements they would be auditing. Accounting firms were reluctant to jeopardize such profitable arrangements by producing unfavorable audits.
The evidence is rather damning. The pious assertions made by the rating agencies to the contrary that, in some situations, ratings firm shopping can lead to vastly different credit-worthiness scores on the same debt instrument. A good example of this credit risk analysis non sequitur is the Four Seasons Resort in Hawaii, which features oceanfront suites that can go for as high as $14,500 per night. The resort actually incurred more debt, yet obtained a higher credit risk rating.
In 2014, the resort’s investment bankers selected Morningstar to rate the company’s $350 million bond offering, collateralized by the property’s mortgage. Morningstar gave ratings to six tranches of the aggregate debt instrument, which ranged from triple-A, the highest rating accorded a corporate debt obligation whose likelihood of default is remote, down a remarkable 14 rungs on the ratings ladder to single-B, which denotes the bond issue is susceptible to losses in a mild recession.
Investment bankers are highly visible players in the shop-for-ratings corporate financing scheme. When the Four Seasons refinanced its obligations in 2017, in a $469 million deal, the resort's investment bankers selected DBRS as one of two ratings firms chosen to assess the credit risk of the new debt. In a remarkable “coincidence” prior to that bond sale, DBRS relaxed its standards for such “single-asset” commercial mortgage deals issued by the resort.
DBRS gave credit worthiness grades three rungs higher than on comparable tranches of the mortgage debt rated by Morningstar in 2014. According to Commercial Mortgage Alert, an industry publication, DBRS’s market share of the ratings business doubled to approximately 26% shortly after its ratings revisions.
Any suggestion by ratings firms that the concomitant increase in market share after loosening credit review standards is merely happenstance strains credulity. After the DBRS ratings changes, unsurprisingly, Morningstar was not about to watch its market share erode because of its lower ratings. It offered to do penance for its temerity in assigning a relatively lower rating than DBRS’s score on the same pools of single-asset commercial mortgage debt.
In June 2018, Morningstar revamped its credit worthiness methodology for these commercial single-asset, mortgage-backed deals, swiftly recouping its market share. Even though Four Seasons' income had increased since 2014, the additional debt meant various slices of the new offering had less cash on hand to repay investors than it had available in 2014. Morningstar issued ratings almost two rungs higher on comparable slices of the same debt rated by DBRS back in 2017.
After receiving the more favorable rating, Morningstar was one of two ratings firms Four Seasons’ investment bankers picked to rate its next debt offering in 2019, a lucrative $650 million contract.
Any assertion by the credit agencies that the converse is true, namely, some issue ratings by one credit review company are substantially lower than that of other firms, is wholly inconsistent with the evidence. One way to test how frequently lower ratings are assigned overall is by reviewing the commercial, mortgage-backed debt instruments, of which investors hold approximately $1.2 trillion.
A statistical review by The Wall Street Journal revealed that DBRS rated these particular bonds higher than S&P, Moody’s or Fitch approximately 39%, 21% and 30% of the time. DBRS issued lower bond ratings approximately 7% of the time. Morningstar rated the bonds higher than the big firms at least 36% of the time and lower 2% to 8% of the time. Kroll, another smaller ratings firm, showed similar results.
Given the glaring, maximize-market-share conflicts of interest that drives the entire ratings process, the best way for investors to assess the default risk of each issuer is to ignore the ratings issued by the credit ranking firms and, instead, consult and read thoroughly the statutory Securities and Exchange Commission disclosure documents or registration statement. This document contains copious and detailed explanations concerning the potential risks for each corporate debt offering.
Any issuer of corporate debt to the public has liability exposure under the Securities Act of 1933 as well as SEC rule 10b-5 for false or misleading statements in connection with a new bond offering. Registration statements are carefully drafted by counsel to ensure that information contained about the offering does not minimize nor misstate the risks.
The mandatory disclosure document presents a far more realistic appraisal of the issuer's credit worthiness that any market share-sensitive firm’s rating can provide. The reasons why are that under the securities laws, not only is the issuer liable for any material, misstatements or omissions concerning the risks of the offering made in its registrations statement, but the investment bankers underwriting the issue are secondarily liable as well.
Until structural changes are made to the rating process, investors should be mindful of high-risk corporate borrowers, whose rosy ratings do not accurately reflect the default risks in connection with the associated offering.
Disclosure: I have no positions in any of the securities referenced in this article.
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