2007 Deja Vu As Bond Issuers Game Rating Agencies Once Again
With home prices rising at near-record paces in SoCal, corporate debt yields at record-lows, equity markets surging at near-record rates, and high quality assets dwindling by the minute under the heel of a central bank jack boot; it is perhaps no surprise that investors have switched from finding leverage through the balance sheet (i.e. crappy quality firms) to finding leverage through the instrument (i.e. structured credit). The trouble this time is that yields (and spreads) being so low, the creators of the new-normal ABS, CDOs, and CLOs have to stoop to the old tricks to make their money (as we noted here). As Bloomberg reports, bond issuers are once again exploiting the credit rating agency pay-for-performance business model to create "high-quality" collateralizable assets from utter garbage - such as auto loans and office buildings.
Deja Vu all over again:
Almost six years after the start of the worst financial crisis since the Great Depression, bond issuers are again exploiting credit ratings by seeking firms that will provide high grades on debt backed by assets from auto loans to office buildings considered inappropriate by rivals.
Fitch Ratings isn’t grading a deal linked to a Manhattan skyscraper after saying investors needed more protection.
The securities won top grades from Moody’s Investors Service and Kroll Bond Rating Agency Inc.
Blackstone Group LP’s Exeter Finance Corp. got top-tier ratings from Standard & Poor’s and DBRS Ltd. in the past 15 months on $629 million of bonds backed by car loans to people with bad credit histories, even as Moody’s and Fitch said they wouldn’t grant such rankings.
Issuers (and structurers) have more room to manipulate than ever before thanks to the unintended consequence of regulation:
U.S. regulators doubled the number of companies sanctioned to assess securities to 10 since 2006.
"Imagine the pharmaceutical industry having six FDAs, all competing to approve drugs," - "everyone would be dead."
But who is to blame?
Issuance of bonds linked to loans and leases are staging a comeback as the Federal Reserve’s unprecedented stimulus, including a pledge to keep benchmark interest rates close to zero into a fifth year, pushes investors into riskier assets.
Banks have arranged $31.5 billion of commercial mortgage-backed securities this year with issuance poised to climb 50 percent from 2012 to $70 billion, according to Credit Suisse Group AG.
Issuance of bonds tied to subprime auto debt of $7.7 billion this year compares with $5.7 billion in the first four months of 2012,
A Specific Example...
Fitch said yesterday in a statement that it was asked not to rate a transaction linked to a $782.8 million loan on the Seagram building at 375 Park Avenue in New York after determining that investor protections were insufficient for top grades.
The mortgage on the tower, designed by Ludwig Mies van der Rohe, allows the borrower to take on higher levels of debt on the assumption that the building will generate more cash in the future. The deal, rated AAA by Moody’s and Kroll, assumes $74 million of income from the property, compared with $54 million as of 2012, according to Fitch.
So-called pro-forma lending was common during the property market boom leading up to a record $232 billion in commercial-mortgage bond sales in 2007, sparking a surge in defaults when properties failed to meet those expectations. The type of underwriting was a “major reason” behind ratings cuts on AAA securities issued from 2005 through 2008, Fitch said in its statement.
Kroll's defense (crystal ball like):
“We tried to take into account the property’s performance and the context of its market,”
and finally summing it all up:
“Nothing’s really changed” in the ratings business, David Jacob, former head of structured finance at S&P
but some are actually trying to stop this:
“My plea today is that you take action,” Franken, a Democrat from Minnesota elected to the Senate in 2008, told participants at the SEC roundtable today. “If we maintain the status quo we are leaving ourselves far too vulnerable to another catastrophe.”
It seems our recent note - from bust to bubble with no recovery in between is increasingly appropriate...
But irony of ironies given the above story in which Kroll is willing to rate on apparently pro forma growth expectations and Fitch isn't, Bloomberg notes...
Jules Kroll, CEO of Kroll Bond Rating Agency, says largest credit rating firms are putting profits ahead of accuracy, "They’re selling themselves out just as they did before," adding that, "If you want to see the next tsunami, wait for outcome in high yield and watch what washes up on shore"
and at the same roundtable, Douglas Peterson, president of S&P Ratings Services, wouldn’t comment on whether market is in “bubble,” saying prices reflect excess liquidity