“The victims are the investors”, as Marshall Glick, a portfolio manager at investment firm AllianceBernstein, told The Wall Street Journal. Greg Michaud, director of real estate at Voya Investment Management, which holds $21 billion in commercial-real-estate debt, agrees.
“We don’t trust the ratings”, he said, as quoted in the same report.
A major contributor to the 2008 financial crisis was collapsing bond values, as vast amounts of debt bearing investment grade ratings proved to be much riskier, and shakier, than the rating agencies had led investors to believe. Highly inflated bond ratings threaten to create a new financial debacle in this multi-trillion-dollar market.
The leading bond rating agencies, SP, Moody’s, Fitch, and their competitors are giving increasingly optimistic ratings as they fight for market share.
Significance for Investors
While the rating agencies are relied upon by investors, they are paid by the companies whose debt they evaluate, creating a serious conflict of interest. Glick was among a group of investment managers who complained to the SEC about inflated ratings, and the ability of bond issuers to shop around for the best ratings.
The Journal analyzed about 30,000 ratings within a database containing $3 trillion of structured securities issued between 2008 and 2019, which was compiled by Finsight.com. These ratings were issued by the three major firms, SP, Moody’s, and Fitch, as well as three smaller competitors that entered the business after the financial crisis, DBRS, Kroll Bond Rating Agency, and Morningstar.
The Journal found that the three newcomers have been more likely than the established rating agencies to issue high ratings, sometimes even issuing top-notch AAA ratings to bonds that other firms have classified as junk. As a result, the expectation among regulators that increasing competition among rating agencies would produce more accurate ratings seems to have failed.
Based on data since 2012, the Journal’s study finds that the 6 rating agencies often have enjoyed temporary increases in market share after changing their rating criteria. This finding suggests that they may bid for more business by relaxing their evaluation methods.
Federal Reserve Chairman Jerome Powell is among those who are concerned. During a speech in May, he singled out collateralized loan obligations (CLOs), debt instruments backed by loans to risky corporate borrowers, and often used to fund acquisitions. “Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards”, Powell said, per the Journal.
To resolve litigation arising from crashing values of debt during the financial crisis. SP paid out $1.5 billion, while Moody’s settled for $684 million, per the Journal. SP admitted that it changed its models in order to gain market share, but neither firm admitted wrongdoing.
Looking Ahead
Stephanie Pomboy, founder of economic consulting firm MacroMavens, is among those who foresaw the subprime mortgage crisis, which preceded the more general financial crisis of 2008. “In 2007, the lie was that you could take a cornucopia of crap, package it together, and somehow make it AAA. This time, the lie is that you can take a bunch of bonds that trade by appointment, lump them together in an ETF, and magically make them liquid”, Pomboy observed during an in-depth interview with Barron’s.
Meanwhile, Chris Senyek, senior macro research analyst, chief investment strategist and lead quantitative analyst at Wolfe Research, is monitoring 10 asset bubbles whose implosion may turn a “run-of-the-mill recession into a full-blown financial crisis”, as he warned in a note to clients that was cited in another Barron’s report. These bubbles include U.S. corporate debt, U.S. leveraged loans, European debt, and even U.S. government debt.
