Co-authors Gene Phillips and Mark Adelson wrote the following article, which was published in the Fall 2020 edition of the Journal of Structured Finance (JSF); it is available in its entirety on the JSF's website at this link.
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The COVID-19 pandemic has had a broad reach, spanning most sectors and industries. This distinguishes it sharply from the mortgage meltdown and the 2008 financial crisis,
which were mostly confined to the housing sector and financial institutions, respectively. Collateralized loan obligations (CLOs), which were largely immune to
the perils of the mortgage meltdown and the financial crisis due to their diversity among corporate issuers, find
themselves exposed by the COVID-19 pandemic.
Rating agencies have been downgrading the speculative-grade loans that support these CLOs en masse: during the four-month period ending June 30, 2020, Moody’s downgraded the ratings of 755 speculative-grade borrowers, a full 31% of the speculative-graderated
universe, across a range of industries (Moody’s Investors Service, n.d.). The industry sectors most
affected are shown in Exhibit 1.
While the loan-level downgrades continue, the rating agencies are also downgrading the CLOs backed by the loans. Meanwhile, corporate defaults are already on the high end. As of the end of July 2020, S&P
reported 98 year-to-date defaults, already surpassing the full-year corporate default tally for 2008, which reached 95 (Serino, Kesh, and Pranshu 2020).
This note focuses primarily on CLO ratings —
but there have been oddities in the rating of residential mortgage-backed securities (“MBS”) during the pandemic as well.
While the credit rating agencies are actively
downgrading speculative-grade corporate loans and
outstanding CLOs backed by these loans, they continue to rate new CLOs at the same time. Their approaches
to this tricky proposition, and their communications
describing their approaches, give us pause. We find that
they are: 1) not being transparent about how they apply
their methodologies, 2) either not applying their methodologies
or not applying them consistently, and 3) not
being consistent in their deviations when they deviate
from their official methodologies.
RATINGS DOWNGRADES
AND NEW RATINGS
In an inauspicious report of May 2020, titled “How
COVID-19 Changed the European CLO Market in
60 Days” (Ryan and Tamburrano 2020), S&P explained that the changes have come “in a sudden and marked
way” and that the “wave of negative [corporate loan]
rating actions has affected several sectors, geographies,
and products.” Strikingly, S&P noted that “[m]arket
challenges that existed before COVID-19, including
high leverage ratios, EBITDA add-backs, and cov-lite
loans, are causing speculation that this may be the perfect
storm for CLOs.”
As of early June, Moody’s had placed 1,100 CLO
notes on watch for possible downgrade. That amounted
to 24% of all CLO notes by count and 7% by balance
(Deshpande, Mogunov, and Chatterjee 2020). The rating
agency stated, “Moody’s actions today follow the CLO
actions Moody’s took on 17 April 2020, and are primarily
prompted by a continuing decline in the credit quality of
CLO portfolios as a result of economic shocks stemming
from the coronavirus pandemic. Since April, the decline
in corporate credit has resulted in a significant number of
downgrades among the assets underlying some CLOs.”
The downgrading continues, but some of it has
been tepid. When downgrading, Moody’s has often
opted for only a single notch downgrade. For example,
on July 1, Moody’s noted significant collateral deterioration
in a CLO called Nassau 2017-II Ltd. The rating
agency stated:
Based on Moody’s calculation, the weighted
average rating factor (WARF) was 3764 as of
June 2020, or 25% worse compared to 3006
reported in the March 2020 trustee report.
Moody’s calculation also showed the WARF
was failing the test level of 3022 reported in the
June 2020 trustee report by 742 points. Moody’s
noted that approximately 40% of the CLO’s par
was from obligors assigned a negative outlook and
7% from obligors whose ratings are on review
for possible downgrade. Additionally, based on
Moody’s calculation, the proportion of obligors
in the portfolio with Moody’s corporate family
or other equivalent ratings of Caa1 or lower (after
any adjustments for negative outlook and watchlist
for possible downgrade) is approximately 30%
as of June 2020 (Aeron and Ham 2020).
Nevertheless, despite significant deterioration,
and in the face of a 30% exposure to Caa1 or lowerrated
assets, Moody’s downgraded the Class C, Class D,
and Class E notes by only a single notch, from A2,
Baa3, and Ba3 to A3, Ba1, and B1 respectively. Moody’s
affirmed the rating of the Class B at Aa2.
In late July, S&P downgraded 63 CLO tranches
by an average of 1.2 rating notches. But 496 tranches
across 287 CLOs remained on CreditWatch negative.
As shown in Exhibit 2, data on the “S&P CLO
Insights 2020 Index” reflected the weakened condition
of the deals.
Meanwhile, the performance of CLOs is to a
degree based on the vigor with which the rating agencies
downgrade the corporate loans. In addition to default
events, downgrades themselves can impact a CLO managers’
ability to trade assets, especially once they start to
fail collateral-quality tests. With CLOs being so heavily
laden with B-rated collateral, even minor downgrades
tend to quickly make an impression on their bucket for
CCC-rated assets.
LACK OF TRANSPARENCY
The rating agencies’ communications around
their ratings actions are confounding. This riddle is no
easier to disentangle when visiting the rating agencies’
remarks. They provide only limited clarity about the
specifics of how (if at all) they are considering the impact
of the COVID-19 pandemic in their rating actions.
When downgrading CLOs, Moody’s mentions that
its “analysis has considered the effect of the coronavirus
outbreak on the US economy as well as the effects that
the announced government measures, put in place to
contain the virus, will have on the performance of corporate
assets” (Deshpande, Mogunov, and Chatterjee,
2020). But there are no specifics: Moody’s does not
explain how. In what ways is Moody’s changing its
approach to reflect the analysis it purports to be making?
Did the prepayment rate assumptions change? Did the
default rate assumptions change? Did the correlation
assumptions change? Did the recovery rate assumptions
change? Given that Moody’s identifies a largely quantitative
methodology article (Kim, et al. 2019) as the
“principal methodology” used in the downgrades, it is
odd that Moody’s did not express its approach in any
way that enables users of ratings to apply the purported
considerations within a quantitative framework.
S&P is similarly opaque. When rating new deals
and reviewing existing deals, S&P sometimes mentions
the pandemic and sometimes does not. For example, in
April, S&P never mentioned the effect of COVID-19 on
its rating of Deerpath Capital CLO 2020-1 (Kalinauskas,
et al. 2020). Moreover, when S&P does discuss the
impact of the pandemic, it does so in a nebulous way,
which leaves the reader guessing about the particulars of
how the rating agency accounts for the pandemic when
assigning ratings. When S&P assigned new ratings in May
2020 to notes issued by Guggenheim CLO 2020-1 Ltd,
its sole mention of the pandemic was the following boilerplate
language:
S&P Global Ratings acknowledges a high degree
of uncertainty about the rate of spread and peak
of the coronavirus outbreak. Some government
authorities estimate the pandemic will peak about
midyear, and we are using this assumption in
assessing the economic and credit implications.
We believe the measures adopted to contain
COVID-19 have pushed the global economy
into recession (see our macroeconomic and credit
updates here: www.spglobal.com/ratings). As the
situation evolves, we will update our assumptions
and estimates accordingly. (Kalinauskas and
Davis 2020).
DEPARTURES AND DEVIATIONS FROM
METHODOLOGIES, AND INCONSISTENT
APPLICATIONS
Beyond the disappointing lack of transparency,
another challenge for investors is that rating agencies
appear to be deviating from their published methodologies
for assigning and maintaining ratings. Moreover,
they deviate in inconsistent ways from one deal
to the next.
Example 1. In one telling example (Jiang and
Vasudevan 2020), Moody’s downgraded 48 MBS
on April 15, 2020. The rating agency identified a
mostly-quantitative methodology as the “principle
methodology” for the rating actions (Vasudevan,
Hannoun-Costa, and Muni 2019). Of note, the principle
methodology predates the start of the pandemic.
What was particularly striking about the April 15
rating actions was that Moody’s downgraded all of 48
MBS to the same rating level (Baa3) even though they
previously carried ratings at a variety of levels (A3, Baa1
and Baa2). Moody’s did not describe a concrete basis for the Baa3 outcome. Although it explained the need for
taking action, it provided no details about why Baa3
was the right rating level for the 48 tranches. The rating
agency stated: “Our analysis has considered the increased
uncertainty relating to the effect of the coronavirus outbreak
on the US economy.” But later in the press release
it revealed that it “did not use any models, or loss or
cash flow analysis, in its analysis” and that it “did not
use any stress scenario simulations in its analysis” (Jiang
and Vasudevan 2020). It is difficult to reconcile that
statement with others to the effect that 1) a quantitative
methodology was used and 2) the analysis considered
the increased uncertainty relating to the onset of the
pandemic.
In June, Moody’s took action on 415 US MBS, confirming
its ratings on 35 of them, while downgrading the
other 380 (Rossetti and Vasudevan 2020). The announcement,
however, contained no language about Moody’s
departing from the application of any models. Instead, the
boilerplate verbiage in the announcement stated:
Moody’s estimates expected collateral losses or
cash flows using a quantitative tool that takes into
account credit enhancement, loss allocation and
other structural features, to derive the expected
loss for each rated instrument. Moody’s quantitative
analysis entails an evaluation of scenarios that stress
factors contributing to sensitivity of ratings and
take into account the likelihood of severe collateral
losses or impaired cash flows. Moody’s
weights the impact on the rated instruments
based on its assumptions of the likelihood of the
events in such scenarios occurring (Rossetti and
Vasudevan 2020, emphasis added).
Most interestingly, 47 of the 48 MBS, which had
been downgraded to Baa3 in April (without the use of
a model), were addressed again in June (Rossetti and
Vasudevan 2020), this time ostensibly using a quantitative
tool. The results were that the securities received
different ratings:
- 10 MBS maintained their Baa3 ratings upon review
with a model.
- 15 were downgraded to Ba2 (i.e., a further two notch
downgrade).
- 22 were downgraded to B1 (i.e., a further four notch
downgrade).
Example 2. In recent surveillance updates on
CLO ratings, Fitch appears to be applying new scenarios
that are not included in its official methodology. For
example, in the updates for Jubilee CLO 2014-XII and
Penta CLO 5, the agency explained:
Coronavirus Baseline Scenario Impact: Fitch
carried out a sensitivity analysis on the current
portfolio to envisage the coronavirus baseline
scenario. The agency notched down the ratings
for all assets with corporate issuers on Negative
Outlook regardless of sector.
∗ ∗ ∗
In addition to the base scenario, Fitch has defined
a downside scenario for the coronavirus crisis,
whereby all ratings in the ‘B’ category would be
downgraded by one notch and recoveries would
be lowered by 15% (Kelmer and Brewer 2020a;
Segato and Brewer 2020a).
More pointedly, Fitch has been regularly deviating
from its model-implied ratings (MIRs) in downgrading
CLOs notes. In addition, the deviations have not been
consistent.
For example, in reviewing certain European
CLOs, Fitch refrained from downgrading tranches for
which the MIR indicated a one-notch drop. Where
the MIR indicated a two-notch drop, the rating agency
either refrained from downgrading[1], or did so by just one
notch[2]. In some cases, Fitch explained that the deviations
were because the MIR results had been “driven by
the back-loaded default timing scenario only” (Choraria
and Brewer 2020; Ishidoya and Brewer 2020; Segato
and Brewer 2020a, 2020b). In other cases, Fitch asserted that it had deviated from the MIRs because the results
did not comport with its view of credit quality and also
because the MIRs had been “driven by the rising interest
rate scenario only, which is not our immediate expectation”
(Kelmer and Brewer 2020a, 2020b).
Fitch made several similar out-of-model adjustments
when reviewing the ratings across seven CLOs in
late July (Torres and Pak 2020). The rating agency stated:
The class C notes in PSLF 2018-4, Ltd., class B
notes in PSLF 2019-4, Ltd., and class B notes in
PSLF 2020-1, Ltd. experienced shortfalls in some
scenarios and the model-implied ratings (MIRs)
of these notes were one notch below their current
rating levels. However, Fitch considered the
magnitude of these failures as minor and isolated
to the back-loaded default timing and rising
interest rate scenario that was given less weight
in the analysis.
∗ ∗ ∗
In addition, MIRs of the following classes were
at least one notch higher than their current ratings
based on current portfolio analyses, but were
not upgraded in light of the ongoing economic
disruption … (Torres and Pak 2020).
In contrast to its surveillance practices, Fitch generally
makes no mention of ignoring its model-based
outcomes in rating new US CLOs. However, in some
cases, Fitch has indicated that it is applying stress scenarios
in a way similar (but not identical) to surveillance
stress scenarios.
For example, when providing ratings to two newly-issued
CLO in July 2020, the rating agency explained:
Fitch has applied two additional stress scenarios
to the indicative portfolio that envisage negative
rating migration as a result of business disruptions
from the coronavirus. The first scenario applies a
one-notch downgrade (with a CCC-floor) for all
assets in the indicative portfolio with a Negative
Rating Outlook.… The second scenario assumes
a 5% increase in the indicative portfolio’s PCM
rating default rates (RDR) for all rating levels.
∗ ∗ ∗
Fitch added a sensitivity analysis that contemplates
a more severe and prolonged economic
stress caused by a re-emergence of infections in
the major economies, before a halting recovery
begins in 2Q21. (See Weiss, Joswiak, and Hughes
2020; Hunter, Lycos, and Hughes 2020, with
emphasis added).
The second stress scenario used in rating new
deals is entirely absent when performing surveillance.
It is unclear whether the downside scenarios are being
applied equally, as Fitch has left the specifics undefined.
It is somewhat surprising that Fitch would choose
to make manual, ad-hoc, overrides to its model-driven
outputs in every pandemic-era CLO surveillance action
we found because it could not rely on the results produced
using its official methodology. Under such a scenario,
it would be easier to understand a basic adjustment
to the methodology (and the associated model), so that it
provides a reliable result that reflects Fitch’s actual views.
WHY IT ALL MATTERS
Investors and other market participants use credit
ratings as signals or indicators of creditworthiness that
figure, inter alia, into their processes for valuing securities
and allocating capital. Securities can also be interrelated.
The ratings awarded to some securities also, as
we note above, directly impact the performance of other
securities that reference or support them. In order for
credit ratings to be useful, they must embody a measure
of reliability. One of the key aspects of that reliability
is that ratings are produced through a consistent, replicable
process: the application of a rating agency’s official
methodologies.
The ideas of applying official methodologies to
produce ratings and doing so in a consistent manner are
prominent features of each rating agency’s code of conduct
(Moody’s Investors Service 2020, § 1.3; S&P Global
Ratings 2018, § 1.2; Fitch Ratings 2017, § 2.1.3). At least
one court has held that statements in a rating agency’s
code of conduct constitute “specific assertions of current
and ongoing policies” and cannot be dismissed as
mere puffery upon which investors cannot reasonably rely, United States v. McGraw Hill (2013). Today, applying
official methodologies to produce ratings is explicitly
required under US [3] and European [4] law .
Likewise, the rating agencies undertake, in their
codes of conduct, to provide clear explanations of the
rationale behind each rating action (Moody’s Investors
Service 2020, § 3.6(b), (c); S&P Global Ratings 2018,
§ 4.1; Fitch Ratings 2017, § 4.1.3). That is also required
under US [5] and European [6] law.
There are compelling reasons for why rating agencies
are required to produce ratings by applying their
official methodologies. One reason is that it decreases
the potential for an individual analyst or team of analysts to abandon criteria in an effort to win new deals by
providing advantageous ratings. Rating agencies might
argue that they must have some flexibility to stray from
their methodologies. To the extent that such a position
is valid (and does not violate a rating agency’s legal obligations),
we believe that when a rating agency deviates
from its official methodology, it has an obligation to
explain the rationale for the deviation and to explain
in detail how it arrived at the rating produced with
the deviation. Moreover, when deviations become the
norm, or when they are inconsistent or poorly articulated,
we believe that the rating agencies have gone too
far. At times, as shown herein, rating agencies have deviated
from their methodologies, but failed to explain the
analyses that ensued and how they determined the final
ratings that they assigned.
CONCLUSION
In the aftermath of the 2008 financial crisis, the
credit rating agencies experienced criticism, private
litigation, and government enforcement actions.
Enforcement actions in the US were taxing, culminating
in f ines of $1.375 billion for S&P and $864
million for Moody’s (US Department of Justice 2015,
2017). The enforcement actions particularly noted that
the rating agencies had violated their codes of conduct,
which required them to provide objective, independent
ratings.
Although the regulatory environment has gotten
tougher since the Dodd-Frank Act was signed into law,
we remain concerned that rating agencies continue to
deviate from their published methodologies whenever
it suits them. Based on recent evidence, they appear to
view the directive to determine ratings pursuant to their
official methodologies and to apply methodologies in a
consistent manner as mere suggestions, rather than as
mandatory rules.
FOOTNOTES
[1] Adagio VII, classes E and F (Segato and Brewer 2020b);
St Paul CLO 5, class F-R (Kelmer and Brewer 2020b); St Paul CLO 6,
class E-R (Kelmer and Brewer 2020b); Jubilee 2014-XII, class F-R
(Kelmer and Brewer 2020a); Jubilee 2016-XVII, class F-R (Kelmer
and Brewer 2020a); Penta 5, class F (Segato and Brewer 2020a).
[2] Euro Galaxy III, class E (Choraria and Brewer 2020); Toro
European 4, class E (Ishidoya and Brewer 2020).
[3] 15 U.S.C. § 78o-7(r) (2018), https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78o-7.pdf; 17 C.F.R. § 17g-8(a)(3)(i), (d) (2019), https://www.govinfo.gov/content/pkg/CFR-2019-title17-vol4/pdf/CFR-2019-title17-vol4-sec240-17g-8.pdf.
[4] Regulation (EU) No 462/2013 of the European Parliament
and of the Council of 21 May 2013 amending Regulation (EC) No
1060/2009 on Credit Rating Agencies, Art. 1, § 10(a) & Annex II,
¶ 1(h), 2013 O.J. (L146/1) at 16, 31 (May 31, 2013), https://eurlex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32013R0462&from=EN; Commission Delegated Regulation (EU)
No 447/2012 of 21 March 2012 Supplementing Regulation (EC)
No 1060/2009 of the European Parliament and of the Council on
Credit Rating Agencies by Laying Down Regulatory Technical
Standards for the Assessment of Compliance of Credit Rating Methodologies,
Art. 5, § 1, 2012 O.J. (L140/14) at 15 (May 30, 2012),
https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0447&from=EN; Regulation (EC) No 1060/2009 of
the European Parliament and of the Council of 16 September 2009
on Credit Rating Agencies, Art. 8, § 2, 2009 O.J. (L302/1) at 13
(November 17, 2009), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32009R1060&from=EN.
[5] 15 U.S.C. § 78o-7(s) (2018), https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78o-7.pdf; 17 C.F.R. § 17g-7(a)(1)(ii)(B), (C) (2019),
https://www.govinfo.gov/content/pkg/CFR-2019-title17-vol4/pdf/CFR-2019-title17-vol4-sec240-17g-7.pdf.
[6] Regulation (EU) No 462/2013 of the European Parliament
and of the Council of 21 May 2013 amending Regulation (EC)
No 1060/2009 on Credit Rating Agencies, Annex II, § 4(f), 2013
O.J. (L146/1) at 27 (May 31, 2013), https://eur-lex.europa.eu/legalcontent/EN/TXT/PDF/?uri=CELEX:32013R0462&from=EN;
Regulation (EC) No 1060/2009 of the European Parliament and
of the Council of 16 September 2009 on Credit Rating Agencies,
Annex II, Section D, ¶ 5, 2009 O.J. (L302/1) at 28 (November 17,
2009), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32009R1060&from=EN.
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Gene Phillips is the CEO of PF2 Securities Evaluations, Inc. in
Los Angeles, CA. gene.phillips@pf2se.com
Mark Adelson is the editor of The Journal of Structured Finance,
in New York, NY. m.adelson@pageantmedia.com
