Of all the amazing scenes in The Big Short, a film about the genesis of the Great Recession, arguably the most shocking is the meeting between a couple of hedge fund managers trying to understand the housing bubble and “Georgia,” a (in a bit of symbolic overkill) visually-impaired executive with the Standard & Poor’s bond rating agency.
Beginning at the 2:15 mark in the following video clip, the money managers demand to know why she’s handing out AAA ratings to clearly high-risk mortgage backed paper. To which she responds,
“If we don’t give them the ratings they’ll go to Moody’s, right down the block. If we don’t work with them they’ll go to our competitors. Not our fault, it’s simply the way the world works. It is not my decision. I have a boss.”
The rating agencies’ blatant corruption contributed to one of history’s biggest bubbles and the subsequent multiyear financial crisis. But at least it taught those guys a valuable lesson and led to changes that will prevent a recurrence.
Just kidding. They learned nothing and are already back at it, this time with collateralized loan obligations, or CLOs. From yesterday’s Wall Street Journal:
Last spring, a real-estate lender hired three ratings firms to rate a series of bonds backed by speculative real-estate loans. Only one of the three got to rate all the bonds. Moody’s Corp. said about half were triple-A. Another firm said about 61% merited that grade. DBRS Inc. said two-thirds.
The winner was DBRS, which had just changed its methodology for rating this type of debt. Moody’s was only hired to rate one of the eight bonds in the deal, and rival Kroll Bond Rating Agency Inc. for a handful. DBRS rated all eight.
The ratings-selection wasn’t unusual: It has become standard industry practice. Fierce competition among ratings firms in a fast-growing corner of the bond market is allowing issuers to cherry pick the most favorable ratings. The result is that securities deemed safe by the ratings firms have increasingly smaller cushions against losses.
The security in question is a cross between two of Wall Street’s hottest markets—commercial mortgage bonds, which are backed by mortgage payments on apartment buildings, malls and the like—and collateralized loan obligations, which are pools of bonds backed by payments on corporate borrowings.
Banks sold a record $21.4 billion commercial-real estate CLOs in 2019, according to commercial mortgage tracker Trepp LLC. That was up from less than $1 billion in 2012 and made it one of the fastest-growing segments of the larger market for commercial-mortgage bonds, Trepp data show.
Issuance is soaring because investors are thirsty for financing to fix up buildings, a popular strategy in hot real-estate markets. Known as transitional loans, these mortgages are often based on a borrower’s plan to turn around a struggling property and fetch higher rents. Such plans might not pan out, making the loans riskier than debt that can be paid off with existing rent payments from a property.
The lenders that make the loans often securitize them by packaging them into bonds sold by an investment bank to investors. That means obtaining ratings from firms like Moody’s or DBRS to help investors judge how risky the bonds are. The firms provide bankers initial feedback on how they might grade deals and get hired based on that feedback. The fees are lucrative and can top $1 million, SEC disclosures show.
As issuance has grown, so has competition to rate the debt. DBRS had the early lead in the sector, rating 10 of 18 deals in 2017. But rival Kroll Bond Rating Agency Inc. began to dominate the sector after it changed its methodology that year. Kroll rated 21 of 25 deals in 2018, according to data from the Commercial Mortgage Alert, which tracks the industry.
A comparison of Kroll’s old methodology and its new one shows that the firm relaxed some rent and occupancy stress tests for mortgages financing multifamily apartment buildings—a big part of the market for these loans. That could yield higher ratings, according to current and former ratings analysts.
So how accurate is the comparison of CLOs with the mortgage bubble? Pretty damn accurate, unfortunately. But not surprising. As expansions enter their latter innings, the people making fortunes by doing various kinds of financial deals realize that the only way to keep the deals (and thus their massive incomes) coming is to relax standards beyond what is normally considered prudent.
So lending standards fall, true risk is hidden in various ways, and hot money pours into ever-less-appropriate places. See, for instance, Signs Of A 2020 Top: “Buyers Return to Riskiest Junk Bonds”.
You see the dilemma here, right? If normal credit standards are maintained, the deal flow ceases and the economy tanks. But if safeguards are corrupted and/or abandoned, the game goes on, and all that capital gravitating towards extreme risk creates a debt bomb that has to blow up eventually. At which point the economy tanks.
In Austrian school of economics terms, over the course of a credit cycle an economy moves from “hedge finance” where debt is used for productive things that actually lower systemic risk, to, eventually, “Ponzi finance” where debt can only be paid off with the proceeds of new, even more risky debt. If past is still prologue, we’re either there or very close.
As Mike Shedlock put it in a recent post, “Fear Has Left The Building.”