Inflated bond ratings helped spur the financial crisis. They’re back.
That was the glaring headline in the Wall Street Journal online on Aug. 7, 2019, when the Journal published my months-long investigation into inflated credit ratings.
The ubiquitous letter grades are a key component of most bond sales since they tell investors the relative riskiness of the bonds they’re buying. A bond rated triple-A is not expected to lose any money while anything rated below the triple-B category is considered non-investment grade and far more susceptible to losses. Many investors follow mandates based on ratings that delineate the types of bonds they can hold, making ratings a crucial part of the financial system.
If credit ratings sound familiar, it’s probably because you’ve heard that they were a contributor to the 2008 financial crisis. Inflated credit ratings issued in the run-up to the 2008 financial crisis cost saddled investors with more than $400 billion of losses on securities that they thought were safe but which turned out to be worthless, according to one study.
As we reported, there’s a long-acknowledged flaw behind ratings inflation that Washington didn’t fix: Entities that issue bonds also pay for their ratings. That gives issuers an incentive to hire the most lenient rating firm because interest payments are lower on higher-rated bonds. Increased competition among ratings firms after the 2008 financial crisis let issuers more easily shop around for the best outcome.
To gauge the impact of increased competition among ratings firms, my colleague Gunjan and I analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019 (read our methodology here). The data, compiled by deal-tracker Finsight.com, allowed a direct comparison of grades issued by six firms: majors S&P, Moody’s and Fitch, and three smaller firms that challenged them since the financial crisis, DBRS, Kroll Bond Rating Agency and Morningstar.
Here’s what we found:
The Journal’s analysis suggests a key regulatory remedy to improve rating quality—promoting competition—has backfired. The challengers tended to rate bonds higher than the major firms. Across most structured-finance segments, DBRS, Kroll and Morningstar were more likely to give higher grades than Moody’s, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back. WSJ, 8/7/2019.
After our August story, we followed-up with additional stories on ratings inflation in other segments of the bond markets, as well as other issues related to credit rating integrity. Here are the major stories in the series:
- “Bond Ratings Firms Go Easy on Some Heavily Indebted Companies” For this 10/20/2019 page-one story, Gunjan and I looked at how ratings firms were giving heavily-indebted companies additional time to pare down their debt instead of downgrading them. Days after the story ran, the lead example we profiled, Newell Brands, was downgraded to junk by S&P.
- “SEC Fix for Conflicts of Interest at Credit-Ratings Firms Has Failed” This 10/29/2019 story examined an Securities and Exchange Commission program aimed at mitigating issuers’ ability to exert influence over credit ratings. The goal was to enable ratings firms to issue unsolicited, and therefore unbiased ratings. Few, if any, such ratings have ever been published.
- “Muni-Bond Ratings Are All Over the Place. Here’s Why.” My colleague Gunjan did a deep-dive into municipal ratings in this 12/6/2019 story, which found widely disparate ratings, errors in analysis and a fight for market share that may have produced optimistic outlooks.
- “Fight for Market Share Gives Bond Issuers Pick of Ratings” I took a closer look at the relationship between ratings firms’ methodology changes and market shares for this 12/29/2019 story that examined a fast-growing segment of the commercial mortgage-backed securities market that was showing signs of ratings inflation.
- “A Borrower Will Be 114 When Bonds Backed by Her Student Loans Mature” This 1/7/2020 page-one story examined the market for bonds backed by student loans, in which bond issuers and investors sought to avoid downgrades of billions of bonds by moving back the bonds’ final repayment dates – sometimes by as much as 54 years. Bloomberg’s Matt Levine wrote a great column on the topic, too.
- “Morningstar’s Big Bet on Bond Ratings Hits Turbulence” This 1/9/2020 story and another story that ran later in January, looked at roadblocks facing Morningstar Inc.’s effort to scale up its credit ratings business.
There have been other developments since we started reporting on credit ratings last August.
Besides downgrades of some of the bonds we profiled, an SEC advisory committee of bond investors began examining alternative business models for ratings firms. Here’s my write-up of the panel’s Nov. 4 hearing in New York.
The SEC has also been getting pressure from lawmakers to take action on the issue. In early February, I wrote about a bipartisan letter from four Senators asking the SEC why the agency failed to revamp the credit-ratings industry’s conflicted business model in the wake of the financial crisis.
Later in February, I traveled to Las Vegas for the Structured Finance Association’s annual conference, where a senior SEC executive gave a speech to the securitization industry about the agency’s credit ratings oversight. Jessica Kane, who runs the SEC’s Office of Credit Ratings, said the agency is rethinking its post-crisis effort to improve the quality of bond ratings. It was a tacit acknowledgment that the decade-old program I profiled in October has failed to meet its objective. Here’s my write-up of Ms. Kane’s speech, which put credit ratings firmly on Washington’s financial regulatory agenda.
The SFA’s conference was probably one of the last events in Las Vegas before city – and much of the country – hit pause due to the coronavirus pandemic. That’s created upheaval ion Wall Street, including bond markets, where the economic impact of the virus has created a massive repricing of risks. I’ve been busy covering the ensuing bond downgrades and risks facing structured products such as collateralized loan obligations, among other things.
I’ll continue to keep an eye on this. As always, if you have any newstips or suggestions for stories, please don’t hesitate to contact me.