Rating Agency Déjà Vu

Short Shrift for Surveillance

There seems to be a scramble on at the rating agencies, but we think we’ve seen this scramble before. 

Beginning late in 2006 the subprime and alt-A residential mortgage-backed securities (RMBS) market began its long downward slide into unimaginable losses.  

The credit rating agencies – of which S&P, Moody’s, and Fitch have the leading market shares – appeared to be slow to respond.  Perhaps there was good reason in the early months of 2007.  Or perhaps not.  An argument against promptly downgrading the RMBS was to wait for a few monthly reporting periods to validate the trend of rising mortgage delinquencies.  The risk in waiting, of course, is that it suddenly becomes “too late” and you are required to implement larger, more frantic downgrades than in the alternative in which you had been downgrading incrementally if and when appropriate.  But while ratings were yet to be downgraded there was no doubt, however, that the values and prospects of both the RMBS and their underlying mortgages were tumbling violently.

We’re reminded of the iconic J.P. Morgan himself who once said (paraphrase):  “Every man has two reasons for doing something.  There’s the reason he gives that sounds good and then there’s the real reason.” 

The rating agencies had at least one “real” reason for not downgrading RMBS bonds promptly: for RMBS and other structured products, they were ill-equipped to provide the services!  From our perspectives having been in the industry, reviewing Congressional testimony and materials from the Financial Crisis Inquiry Commission, and having conferred with others playing similar roles at other agencies, we can tell you that the rating agencies did not have the capacity to methodically or efficiently oversee their models and ratings on the RMBS bonds they purported to be monitoring.  There was very little that was programmatic to it.  The process for the supposedly continuous, ongoing surveillance of thousands of RMBS bonds was (shockingly) manual.  Or it was not done at all.

The rating agencies were much more concerned with clipping high revenue-generating new deal rating tickets, and much less concerned about providing the required surveillance on existing deals.  Monies for surveillance, after all, get paid whether or not the service is provided.

So the RMBS downgrades came in waves spaced out over many months in 2007.  The rating agencies placed many bonds on downgrade watch prior to the requisite modeling and analysis based on mortgage characteristics, transaction vintage, and broad market performance.  This “watch period” supposedly bought the rating agencies time to perform the actual analysis before specifying actual downgrades.

Of course, while the existing ratings were intermittently “wrong” or awaiting correction, there was much ado about how to rate new deals or other existing deals that depended on those outstanding – but yet to be addressed – ratings.

Now it’s 2020 and we wonder if the ratings surveillance process has improved at all.  The tremendous economic stress of the coronavirus (“COVID-19”) raises doubts of the sudden inability of homeowners to continue making mortgage payments.  Many of these debtors are now unemployed with much uncertainty for the future.  The house prices themselves may be greatly depressed – we won’t know until the end of this suspension period for real estate transactions. Falling home prices in 2007-2008 themselves prompted many mortgage defaults.  Thus, it’s fair to say that RMBS bonds have much greater risk of default than they did at the beginning of the year.

Moody’s acknowledges the impact of the coronavirus, and the substantial uncertainty it brings with it.  

“Our analysis has considered the increased uncertainty relating to the effect of the coronavirus outbreak on the US economy as well as the effects of the announced government measures which were put in place to contain the virus. We regard the coronavirus outbreak as a social risk under our ESG framework, given the substantial implications for public health and safety.”[1]

Importantly, Moody’s accepts that “It is a global health shock, which makes it extremely difficult to provide an economic assessment.”  However, Moody’s is in the business of making these assessments, meaning it needs a robust and methodical way of tackling the new variable, and accounting for the uncertainty that comes with it. 

The rating agencies have two very interesting vocations at present. 

First, they’re actively downgrading RMBS (and most other bonds too).

Next, they’re actively rating new deals, even though some of the new deals are backed by assets that they’re simultaneously downgrading.  For example, rating agencies rated five new CLO deals, backed by loans in April; meanwhile, as of early April JPMorgan was showing that loan downgrades were outpacing upgrades at a rate of 3.5-to-1.

Part 1: Ratings Downgrades

Moody’s announced, on April 15, its placement of 356 RMBS bonds on review for downgrade and the actual downgrade of 48 bonds to the Baa3 level.[2]  The downgraded certificates remain on watch for further downgrade.

Placing bonds on watch for potential downgrade is not, alone, all that interesting.  But the downgrades were interesting.  Moody’s rationale:

“The rating action reflects the heightened risk of interest loss in light of slowing US economic activity and increased unemployment due to the coronavirus outbreak. In its analysis, Moody's considered the sensitivity of the bonds' ratings to the magnitude of projected interest shortfalls under a baseline and stressed scenarios. In addition, today's downgrade of certain bond ratings to Baa3 (sf) is due to the sensitivity of the ratings to even a single period of missed interest payment […]”

There are a few things that are interesting here. 

First, the lack of specificity. Moody’s does not specify any quantitative elements of its analysis – Moody’s does not cite to changes in default rates, severity rates, recovery rates or prepayment speeds – that were adjusted to accommodate COVID-19 or that justify the downgrade action or explain the specific rating as Baa3, which is (curiously) the lowest level of investment-grade.  It is all rather vague.

Second, you might have noticed some unusual language there.  The “downgrade of … ratings … is due to the sensitivity of the ratings…”  That is all meaningless. One does not downgrade a rating because of the sensitivity of the rating.  All ratings, aside perhaps from some Aaa ratings, are “sensitive.”  One downgrades because of a higher potential for default or loss, as ascertained by an analysis performed – not because of the sensitivity. 

That brings us to the next issue: what analysis was performed?  The short answer is, well, that there was no proper analysis performed!  Aside from Moody’s failure to describe the specific analysis performed, we have at least two reasons to believe that no analysis was performed. 

1. Moody’s does not have a methodology for incorporating the coronavirus stress: Moody’s explicitly acknowledges that the principal methodology used in these ratings was the "US RMBS Surveillance Methodology" published in February 2019, which of course was pre-COVID-19
2. Moody’s acknowledges that it did no modeling: “Moody's did not use any models, or loss or cash flow analysis, in its analysis. Moody's did not use any stress scenario simulations in its analysis.”  

Why does it matter that Moody’s did no modeling?  Because the Feb. 2019 methodology referenced is a quantitative one, and it requires extensive modeling.  One simply cannot apply a quantitatively-heavy methodology while applying no models.  Ergo, we suspect that Moody’s did not apply, or could not have properly applied, the Feb. 2019 methodology.

Altogether, we see 48 bonds downgraded to Baa3, absent:

• an updated methodology that reflects the key new coronavirus risk, despite acknowledgment of the key importance of this risk to the deals;
• a proper application of the existing methodology from Feb 2019 or any explanation as to the deviations from the methodology; and
• the application of any models at all.

It is commendable to tell investors that you have not modeled cash flows, or performed any stress scenario analyses.  But the questions are then: What was done and how exactly did you arrive at a Baa3 rating? What is the point of publishing a ratings methodology if you are not going to follow it, or describe specific deviations from it, so that investors can similarly follow your reasoning?

Strictly speaking and adhering to the meaning of Moody’s ratings, it is extraordinarily difficult to imagine how Moody’s could determine that 48 bonds should simultaneously earn the new, lower rating of Baa3 without analysis.  With no quantitative estimate for increased loss or diminished and re-directed cash flow, how can Moody’s determine the precise new rating level?

One thought, however, is that Moody’s guessed at the rating based on the methodology, and perhaps because there were no models to apply: in the rush of rating new deals, maybe Moody’s hadn’t gotten around to building well-functioning models to replace the old ones?  Or, equally plausible is the possibility that Moody’s models do not exist in the cloud, meaning that the Moody’s analysts and supervisors working from remote (home) locations could not access the necessary models, data or tools to perform their reviews. What an astounding disclosure this would be, if true, for a global data-centric organization!

Whatever the reason, the Baa3 ratings are flawed.  No analysis by an outsider, or perhaps even a Moody’s insider, when applying Moody’s methodology, can credibly achieve an outcome of Baa3.  It is just a guess.

Part 2: New Ratings

The rating agencies are actively downgrading bonds, loans, and credit instruments across most sectors and industries.[3] Many of these downgrades may be well-intended, due to newly introduced COVID-19-related risks.  But while they are downgrading these (newly unstable) credits they are rating new structured finance credits that are supported by these very same unstable credits.  Their structured finance ratings problematically look to their own ratings of the credits, which are being downgraded daily.  Thus, new ratings cannot be said to be robust to the degree the rating agencies lack confidence in the sturdiness of their own underlying ratings.  Moreover, the new structures are not being rated according to any new, post-coronavirus methodology.  So we might expect those newly-created bonds to be similarly downgraded, too, in short order. 

When S&P rated Harriman Park CLO, a new deal, on April 20th, S&P said nothing at all about coronavirus in its press release.  In explaining how it came about its ratings, S&P cited only to related criteria and research from 2019 and earlier.  There is no evidence that any scenario was run at all differently by S&P.  No mention is made of any newly-imposed stress scenario being run. 

When Fitch rated this same deal, Fitch explained its thought process and how it is deviating from its pre-existing methodologies.  That’s a whole lot better than S&P in this case, but even Fitch failed to explain the “why.”  Fitch simply explained what it is doing, but not why what is doing makes sense.  How have they calibrated their models (if at all)?  How do we know the new assumptions are adequate or comprehensive? 

“Coronavirus Causing Economic Shock: Fitch has made assumptions about the spread of the coronavirus and the economic impact of related containment measures. As a base-case scenario, Fitch assumes a global recession in 1H20 driven by sharp economic contractions in major economies with a rapid spike in unemployment, followed by a recovery that begins in 3Q20 as the health crisis subsidies. As a downside (sensitivity) scenario provided in the Rating Sensitivities section, Fitch considers a more severe and prolonged period of stress with a halting recovery beginning in 2Q21. 

Fitch has identified the following sectors that are most exposed to negative performance as a result of business disruptions from the coronavirus: aerospace and defense; automobiles; energy, oil and gas; gaming and leisure and entertainment; lodging and restaurants; metals and mining; retail; and transportation and distribution. The total portfolio exposure to these sectors is 9.9%. Fitch applied a common base scenario to the indicative portfolio that envisages negative rating migration by one notch (with a 'CCC-' floor), along with a 0.85 multiplier to recovery rates for all assets in these sectors. Outside these sectors, Fitch also applied a one notch downgrade for all assets with a negative outlook (with a 'CCC-' floor). Under this stress, the class A notes can withstand default rates of up to 61.8%, relative to a PCM hurdle rate of 53.9% and assuming recoveries of 40.6%.”

While it continues to rate new deals, S&P (for example) has placed roughly 9% of all its CLO ratings on watch negative since March 20th.[4]

The rating agencies suffered tremendous reputational damage when they were found to be rating new CDO deals in 2007 while they already knew they could no longer rely on the RMBS ratings supporting those deals, as they would imminently be downgraded.  Once the CDO rating analysts knew the RMBS ratings were unstable and about to be downgraded, the CDO analysts were taking a legal risk in producing ratings they knew would not be robust.  It can be difficult to turn away the sizable revenues that come with rating new deals – even when you do not have a sustainable ratings methodology or any conviction in the credibility of the data (including ratings) you are relying on.

The essence of formulating credit ratings for all entities (structured, corporate, municipal, etc.) requires the ability to estimate future revenues, expenses, and liabilities for a multi-year time period.  Such estimates are critical to the rating process.  As we write, forecasting for the broad economy and for most specific entities is highly uncertain.  We do not see how it is possible to perform meaningful rating analysis amidst this uncertainty.  Hence, the credit rating agencies should arguably pause all new ratings until uncertainty declines or until they develop rating methodologies that fully incorporate the wide uncertainty. 

Part 3: Summary/Conclusions

Stale ratings, inflated ratings and other faulty ratings can sometimes go unnoticed during an upswing. But shortcomings become most pronounced during an economic downturn or crisis.  We are concerned that we are (again) seeing the result of years of prior, weak, ratings mismanagement.

When crises occur, rating agencies should be able to swiftly update their methodologies, models and ratings.  And rating agencies should stave off rating new deals until and unless they have strong and current methodologies in place to explain their new ratings and how their ratings accommodate the upheaval, whatever it may be.

Rating agencies seem quickly to have forgotten (or simply to have ignored) the lessons they should have learned from the last crisis.  Regulatory settlements with the DOJ for subprime crisis-era misconduct (S&P for $1.375 billion[5], and Moody’s, in the amount of $864 million[6]) concerned issues in which they deviated from their code, which required them to provide objective, independent ratings.  Those were not about the rating agencies being wrong, or failing to predict the downturn, but closer to argument that the rating agencies failed to believe their own ratings.[7] 

In the above case, we would have to ask how Moody’s can be sure that Baa3 is the right rating – for all 48 bonds, across different deals, structure types and vintages – consistent with its methodology, given it failed to apply any modeling? 

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This article was co-written by Joe Pimbley, who consults for PF2.

1. https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633
2. https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633
3. https://www.wsj.com/articles/bond-downgrades-begin-amid-coronavirus-slowdown-11585045800
4. https://www.opalesque.com/industry-updates/5969/96-reinvesting-clo-ratings-placed-on-creditwatch.html
5. https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-1375-billion-settlement-sp-defrauding-investors
6. https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-nearly-864-million-settlement-moody-s-arising
7. https://www.bloomberg.com/news/articles/2013-02-05/s-p-won-t-employ-first-amendment-defense-in-u-s-ratings-lawsuit