RiskMay 22, 2020

Credit Raters Get Slammed Once Again as Too Lenient

S&P and Moody’s take it heavy in an SEC hearing. A run-up to a replay of their 2008-09 vilification?

Reported by Larry Light

The big credit rating agencies came under fire at a Washington hearing Thursday, in what may be a curtain raiser for a new assault on how they do business. All very reminiscent of the flak they got due to the financial crisis a dozen years ago.

Appearing before a panel of the Securities and Exchange Commission (SEC), critics lambasted the agencies—primarily the biggest, Moody’s Investor Service and Standard and Poor’s—for being too lenient on the companies and other debt issuers that they rate.

The raters were guilty of “overvaluation” of many debt issuers in the previous crisis and they still are, said Marc Joffe, senior policy analyst at the Reason Foundation, the libertarian think tank.

The agencies took a public pasting in the wake of the 2008-09 crisis because of their thumbs-up grades for investment vehicles laden with toxic mortgages, which ended up going bust and losing investors a lot.

As a consequence, regulators and Congress compelled them to make greater disclosure of their methods and also allowed more federally sanctioned competitors. The result, though, is that none of these fledgling rivals has come close to threatening the big two, or their smaller peer, Fitch Ratings.

Now, as a harsh recession (thus far unofficially declared) gathers force, a rash of business failures is expected. Leading up to today’s coronavirus-induced economic downturn, there has been Wall Street grumbling that the agencies allowed too many highly indebted companies to remain in investment grade. Lately, and detractors would say belatedly, several have been downgraded to junk status, with a lot more to come.

Joffe complained that two commercial mortgage-backed securities, which package bonds backed by real estate loans, have been highly rated—and now are shuttered, due to the pandemic lockdown, which makes their futures questionable. One such investment pool is attached to Destiny USA, the mega-mall in Syracuse, New York, and the other to the MGM Grand and Mandalay Bay casinos in Las Vegas. Neither company could be reached for comment.

Joseph Grundfest, a Stanford law professor, told the SEC committee that the “duopoly” of S&P and Moody’s needed better competition. His suggestion: a new agency, sponsored by institutional investors who are the buyers of rated debt. “Otherwise,” he said, “we’re just fiddling around the edges.”

Van Hessen, chief strategist at upstart Kroll Bond Rating Agency, said too many bond buyers depend on the large agencies’ letter ratings (AAA from S&P, for instance, is top of the line), when they should be looking at other factors, such as odds of default. Kroll, which was founded in 2010, touts its own letter grades as giving greater weight to default risk.

Defending S&P, its head of global ratings services said that since the ’08-’09 crisis, the major agency has been subject to much more regulation. “That has been a transformation,” Yann Le Pallec said. S&P was vigilant at preventing conflicts of interest, he added, such as by banning analysts from sales pitches.

“We agree that people shouldn’t just rely on us” when assessing buying bonds, he said.

It’s doubtful that the SEC, under the more lenient rule of Chairman Jay Clayton, is about to start cracking down on the big raters anytime soon. Still, if a rash of failures of well-rated issuers happens, the widespread lambasting of the agencies could well recur.