Experts Warn of the Continued Divergence between Credit Rating Agencies

Today’s post looks at a recent article produced by credit rating experts Marc Joffe and Joe Pimbley. In the article entitled ‘Mall Shooting Highlights Folly of Single Asset CMBS Ratings’, Joffe and Pimbley discuss how recent events at the Destiny USA Mall in Syracuse have highlighted underlying and, arguably, fundamental issues within the credit rating arena in relation to CMBS – Commercial Mortgage-Backed Securities. In this review of their article, we will examine this issue more closely, along with the points made by the article in question.

First, some context. On the most recent ‘Black Friday’, the Destiny USA Mall in Syracuse (New York) fell victim to a shooting attack, within which a victim received wounds in the leg. Then, only the very next day, ‘at least one person was stabbed during a fight at Apex Entertainment inside Destiny USA’. Here in Financial Regulation Matters we have, admittedly from a majoritively British perspective, analysed the diminishing health of the bricks-and-mortar retail industry, and the US is no different. According to data compiled and analysed by Credit Suisse, between 20 and 25% of all American malls will close by 2022. Although the authors do not suggest that these factors mean that any securities offered by Malls may not be creditworthy as a result, they do suggest that the large amount of factors affecting Malls in the US, on top of any negative press that may hasten the demise of a Mall, means that instances such as S&P and Kroll’s AAA-rating of $215 million (of a total securitised package of $430 million) are worth analysing further.

As part of the structured package put together by Destiny USA, the structure dictates that ‘a credit event that forces a write-down of the underlying mortgages by more than 50% will trigger losses on the AAA (senior) notes’. The authors correctly argue that, whilst this event may be unlikely, it is certainly not unimaginable – the large amount of factors affecting the retail marketplace mean that assigning the top-rated ratings to a structured product put forward by such entities is potentially hazardous. The scholars put it much better when they state that, for S&P for example, the agency ‘expects AAA bonds to have a default probability of 0.15% over any 5-year period’. The scholars then go on to ask just how an agency can ascribe such a definitively positive label to a single property, even when that contains multiple businesses, where the potential for a 50% loss is arguably much greater than 0.15% (on the proviso that senior notes will become negatively affected if the entire securitisation suffers more than a 50% loss). The article continues by discussing how Moody’s and Fitch Ratings have assigned ratings to similar bonds (supported by Mall revenues) as Ba2 (speculative grade) and BBB respectively.

Joffe, in 2015, discussed how the CMBS marketplace, whilst not similar in size or stature to the Residential Mortgage-backed Securities (RMBS) marketplace that decimated the global economy in 2007/8, did similarly contain inherent issues from a rating agency perspective; namely, ratings shopping. In the RMBS era, the shopping took place between the top 2 or top 3 agencies, but for the CMBS marketplace the shopping is spread across the top 6 agencies. It has been argued, therefore, that previous issues affecting S&P with regards to their CMBS rating provision – S&P were suspended from rating conduit/fusion CMBS in 2011 - have affected their approach to the marketplace. Joffe, in 2015, declared that the SEC’s enforcement actions ‘cemented S&P’s also-ran status’, and that now ‘we don’t know when the next financial storm will occur or what it might look like, but overrated commercial mortgages are clearly a vulnerability’. In addition, Joffe discussed in 2015 that the SEC’s enforcement action had led to Kroll capturing S&P’s share of the CMBS market and that the behaviour that led to the settlement – ‘distorting a Great Depression data set to justify lower AAA credit enhancements’ – was likely motivated by the fear of losing out to a competitor in what is a particularly lucrative marketplace, or at least an attempt to recapture its former status held before the suspension in 2011. Nevertheless, the SEC labelled this behaviour as ‘race-to-the-bottom’ and that it is something the SEC would not tolerate. That is all well and good, but it is one of the fundamental issues within the rating arena; the rating oligopoly does not function optimally with increased competition enforced upon it, which is something legislators and regulators have been trying to do for the past decade, at least.

Ultimately, Joffe and Pimbley are absolutely correct in their identification of an issue on the horizon. They are correct in their analyses regarding the relative size of the CMBS market in relation to the RMBS market, but their understanding is accurate that an issue within the CMBS market could be massively impactful. The connectedness of the modern marketplace means that a tremor in one sector must be felt in another; the question then becomes how many other sectors may be affected, and how strong was the initial impact in the original sector. This is perhaps a perfect demonstration of why the continued critical analysis of the agencies is tremendously important, because of their centrality to that interconnectedness. Joffe and Pimbley conclude with the warning that rating agencies should take a harder, more sceptical look at collateralised deals before the clouds start gathering (which is true), but perhaps that same message needs to extrapolated further in that regulators need to take a harder, more sceptical look at the agencies and their role in the system before clouds start gathering, systemically. This is, of course, a common request of regulators, but it does not detract from its accuracy – the agencies will be involved in another financial scandal because, quite simply, the financial system and the agencies’ connection to it determines that they will be central to a future failure in the marketplace. Perhaps that could be the starting point to a regulatory strategy, or perhaps it is just not optimal to do that in terms of allowing the growth of particular markets?

Keywords – credit rating agencies, CMBS, Mall, @finregmatters