Fierce competition may be encouraging risky rating agency behaviour, writes Al Barbarino
Since the financial crisis, the US Securities and Exchange Commission has sought to encourage competition among rating agencies. Its new rule 17g-5 aims to give new market players a voice by seeking their frank opinions on the creditworthiness of structured financial products, like CMBS.
The rule requires issuers to share data on forthcoming deals online so that all the recognised rating agencies can provide “unsolicited commentaries”. But with the US CMBS market heating up and the credit quality of new issues a hot topic, the rule has fuelled fierce competition among agencies, which sources tell Real Estate Capital has encouraged a “gaming” of the system.
“Agencies want to be responsible and open, but if they are open they feel they’re going to [lose the deal],” says an executive at a bank that issues and buys CMBS. Some say fierce competition, which the new rule has helped to foster, has led some agencies to tailor credit enhancements to win deals. In turn, CMBS issuers have more incentive to shop around for the best rating, or might try to lean on agencies to assign better-than-warranted ratings.
“Some have raised the level of credit enhancement more than others,” says Kim Diamond, head of structured finance at Kroll Bond Rating Agency, a relatively new CMBS market entrant. “Some have taken a more responsible view.” Issuers structure CMBS to improve the top-grade tranches’ credit quality, and earn a higher rating, by including subordinated B-rated tranches, which provide a cushion to absorb losses from the underlying loans.
Diamond says some agencies aren’t raising enhancement levels as much as they should, especially at the “BBB-minus” level, which marks the break between investment-grade and non-investment grade and has “a big impact on the profitability of the deal… It’s a very important category relative to getting selected or not selected for rating deals.”
Earlier this year, Fitch sounded the alarm on risks in several deals, noting that ratings of ‘BBB-sf’ through ‘Bsf’ on many large 2014 loan deals “are not warranted, given the significant amount of debt at those ratings.” For example, Standard & Poor’s rated as AAA a $260m top tranche of $460m suburban offices securitisation GP Portfolio Trust 2014-GPP; Fitch said it would have given it a lower AAsf and felt S&P’s BBB-sf ratings would have earned a B-sf from Fitch.
Kevin Duignan, global head of securitisation and covered bonds at Fitch Ratings, says that in many deals it has seen in the past year “we do not believe enhancement has increased sufficiently, particularly at the subordinate levels. Therefore we are not rating those transactions.”
Rule 17g-5 was meant to curb such behaviour, but seems to be having the opposite effect. “Ratings subordination levels have an impact on our profitability, so you see people doing things that don’t make sense,” the bank executive says. The rating agencies Real Estate Capital spoke with, including Kroll, Fitch Ratings, Moody’s, Morningstar and S&P, all denied tailoring credit enhancement levels to win deals.
The pros and cons of open commentary
Issuers normally get indicative ratings for new issues from many agencies before choosing which one(s) it will hire to rate the deal. The idea of making issuers share data with all agencies is to encourage “unsolicited commentaries”, so that the voices of those not hired to rate a deal will foster accountability, protect investors and increase competition. “We feel comfortable stating our opinions to investors on structured finance deals even if we weren’t hired to rate them, if our position differs substantially from other agencies,” says Fitch Ratings’ Kevin Duignan.
However, other agencies say the “unsolicited commentaries” are incomplete without a dialogue with the issuer. “To do a true rating, we need to do the fullblown analysis,” says Ken Cheng, CMBS new issues MD at Morningstar Credit Ratings. “To perform the detailed analysis we do when we engage on a deal and not get paid for it is not a business model that works for us… The commentaries are not a complete analysis and
that doesn’t paint a full picture for investors.”