During the Great Financial Crisis, Overly Optimistic Ratings Helped Kill the Market. Could It Be Happening Again?
As far as financial instruments go, collateralized loan obligations (CLOs) are relatively young investment vehicles. First introduced along with collateralized debt obligations (CDOs) in the 1980s, the structured finance securities have undergone precious few economic cycles for investors to understand how they will perform under different markets. They’re incredibly complicated investments for investors, who have to rely on credit ratings to ascertain how risky they truly are.
But the trouble with relying on credit ratings was thrown into sharp relief during the 2008 housing crisis when the CDO market imploded. Regulators at the time accused credit rating agencies of failing to represent the risks of CDOs and being too slow to downgrade the opaque and murky products.
Compared with CDOs, CLOs took a minor part in that debacle, and investors managed to recoup some of their losses. But a recent report suggested that the disconnect between rating agencies and the larger economy could mean that history could repeat itself.
A study from the Massachusetts Institute of Technology (MIT) Sloan School of Management that explored the disparity between ratings for collateralized loan obligation tranches and their underlying securities found that CLO investments could be riskier than their ratings have them appear.
About one-quarter of collateral going into collateralized loan obligations was downgraded by rating agencies Standard and Poor’s (S&P) and Moody’s during the pandemic, according to the report. But CLO tranche values were reduced just 2% over the same time period.
What is the reason for the disparity? Researchers said the most likely causes are either that issuers are allowing potential conflicts of interest to get in the way of their security ratings or that portfolio managers are strategically making CLOs appear less risky than they truly are.
First, the report found that rating agencies concentrated the bulk of their downgrades on the most junior tranches, where investors are already taking on the highest risk of default, versus the senior tranches typically preferred by risk-averse institutional investors such as pension funds. That should not be the case given the modeling guidance, the report said.
“When you consider the model, the model would suggest that the downgrading actions would be more uniform across tranches,” said Jordan Nickerson, author of the report and visiting professor at MIT.
The disconnect suggests that “non-model considerations,” or some undisclosed biases, were factored into ratings.
Second, the study, which evaluated whether portfolio managers have changed their behavior in response to the coronavirus crisis, found that they were actively trading and buying loans with shorter maturities, meaning two-year loans versus four-year loans, that rating agencies tend to evaluate as safer. If portfolio managers reinvest two-year CLO loans, however, it’s not really clear from an economic standpoint how the two-year loan is less risky than the four-year loan, according to Nickerson.
While there could be other reasons why collateral managers do this, Nickerson said that “if they were responding to rating agency models, it would look like this.”
Other academic studies in the past have explored whether rating agencies have been overly optimistic going into a crisis. But Nickerson said the authors of the report are more interested in whether potential conflict of interest at rating agencies are slowing the rate at which they downgrade securities.
Of course, allegations of bias and potential conflicts of interest at rating agencies have been explored before, particularly in the aftermath of the financial crisis. In 2015, the Department of Justice (DOJ) agreed to a $1.4 billion settlement with S&P after alleging the ratings agency defrauded investors, as well as misrepresented ratings as objective and uninfluenced by business interests.
“As S&P admits under this settlement, company executives complained that the company declined to downgrade underperforming assets because it was worried that doing so would hurt the company’s business,” Former Attorney General Eric Holder said in a statement at the time. “While this strategy may have helped S&P avoid disappointing its clients, it did major harm to the larger economy, contributing to the worst financial crisis since the Great Depression.”
Indeed, the MIT report also found that at least one rating agency has stated in its disclosures that it ultimately decides ratings in a committee.
However, in a blog post this month, S&P author Alexandra Dimitrijevic defended the rating agency against common criticisms of its methodology. In response to criticisms that ratings can be overly positive before a crisis, the author argued that credit ratings should reflect “the most current information and evolve if and when circumstances change.”
In addition to quantitative testing and cash flow modeling, the ratings agency in April added other qualitative factors to generate ratings for CLO tranches that consider ratings on a “transaction-by-transaction” basis. The S&P said it plans to apply cushions to tranches to account for volatility in the underlying securities.
In response to this story, a spokesman for Moody’s said its credit ratings are based on a “rigorous analytical process and robust methodologies” that are publicly available.
“CLO tranches that carry a Moody’s rating of Aaa benefit from strong structural protections and continue to perform well despite the unprecedented economic fallout caused by the global pandemic,” the spokesman said.
“We review our ratings on an ongoing basis and take action where appropriate to reflect our forward-looking views of credit risk,” he continued.
Still, the study warns that pension funds and other institutional investors should evaluate risk before purchasing preferred tranches of CLOs. As the country lurches into a tumultuous fourth quarter that could include an onslaught of corporate defaults, investors should carefully consider their options.
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