It has been seen as a major cause of the global financial crisis, and regulators have spent over a decade stamping out the practice. However, Kroll Bond Rating Agency Inc.'s $ 2 million fine last week shows that the battle against rating shopping has never really been won in the securitized debt market.
Kroll ruled with the Securities and Exchange Commission for non-compliance with the rating standards for commercial mortgage bonds and secured loan obligations, just months after rival Morningstar Credit Ratings LLC (DBRS Morningstar) was ruled by Morningstar Credit Ratings LLC (DBRS Morningstar) had been given an even greater penalty regulator.
The recent fines are fueling concerns that rosy credit ratings are masking deeper structural problems with the securities. The risks are particularly acute in the CMBS market, where coronavirus pandemic stoppages have weighed on revenue for shopping malls, hotels and other commercial properties that support the debt and have sparked a number of downgrades.
"The problem of rating shopping and inflation remains unsolved," said Jeffrey Manns, a law professor at George Washington University. “This example from Kroll shows that rating agencies may still be under pressure to optimize their methods of doing business. In good times these issues don't matter much, but in bad times these intrinsic issues become more prominent. "
The practice of rating shopping, in which borrowers seek out issuers who they believe will get top marks, relies on the fact that rating firms are paid by the companies that sell the securities.
Since the financial crisis, commercial mortgage-backed securities have been designed to be more secure than they were before, including lower debt relative to assets. Underwriters are now also not assuming that real estate will have a high income for their entire life, but are basing their forecasts on current cash flows.
However, according to the SEC, Kroll allowed his CMBS analysts to adjust their assumptions about how much a building's revenue would drop if a loan defaulted, as tenants, for example, may be less willing to renew their leases in this scenario. The adjustments had a material impact on final ratings of bond deals, but did not require any analytical method to determine when and how those adjustments should be made, the SEC said in a statement Tuesday.
The regulatory authority also asserted that Kroll was not obliged to record the reasons for these adjustments.
Morningstar's $ 3.5 million fine was related to using asset-backed rating analysts to market the company's services in a conflict of interest rule, according to the SEC. Both Kroll and Morningstar have stated that they stand by the integrity of their ratings and have neither approved nor contested the results of the SEC.
Rating shopping has historically been the most problematic issue in the securitized debt market, as the structures of the securities depend heavily on the individual rating firms' models, and the graders with the mildest models can win more business as long as their ratings persist believable.
Prior to the 2008 financial crisis, rating firms had a "race to the bottom," relaxing their rating standards for mortgage-backed securities and secured bonds to avoid losing market share, the Senate Standing Subcommittee on Inquiry wrote in a 2011 report.
Despite attempts by regulators in the years that followed to hold the industry accountable, the problem persists.
Around 2014, as smaller movers and shakers like Kroll and Morningstar took market share from bigger rivals, some of the biggest CMBS buyers complained to the SEC that the shift was leading to riskier, higher-rated deals and asked regulators to intervene.
Even the larger rating firms were scrutinized. The SEC fined S&P and banned the company from much of the CMBS market for one year in 2015. Three years earlier, she had watered down her requirements in order to win business without telling investors.
"It wouldn't be surprising if an economic downturn like the current one exposes the structural problems of securitization ratings and makes this a focus," said Manns of George Washington University.
The overall CMBS crime rate rose from 2.3% in April to 10.3% in June, the highest level since 2012, according to data from industry tracker Trepp. In the latest August report, arrears were around 9%.
"The rating system is unfortunately broken," said Marc Joffe, senior policy analyst at the Reason Foundation, a libertarian think tank and former Moody & # 39; s Analytics employee and contractor for Kroll. “While this recession may not be as deep as the last, there are some similarities. Last time there was a real estate bubble. This time there was a commercial real estate bubble. It only takes one thing to pop and this time it was Covid. "