Rating agency redux

Record low interest rates and strong stock markets could be masking the return of some very bad habits.

With a record strong economy and markets seemingly the new normal, we’re wondering if politicians have much incentive to nudge regulators to check behind the curtain. While there are many undeniably positive factors contributing to growth and bull markets, we are also seeing a troubling replay of corporate debt levels and complex securitized structures — two things that the Financial Stability Oversight Council (FSOC) should not ignore.

Going back to 2006 and on the eve of Global Financial Crisis (GFC), the Securities and Exchange Commission enacted the Credit Rating Agency Reform Act. At the time credit rating agencies (CRAs) seemed to have been bitten by the subprime boom, inflating ratings on poorly analyzed and suspect credit derivative structures. CRAs were trying to suit the issuer who was paying for the ratings, but also to capture a much bigger investor base with what turned out to be bogus, investment-grade ratings. It was a bonanza for the CRAs until the subprime music stopped.

As it turned out, not long after the GFC, the poor ethics of these CRAs and their conflicted practices were identified as contributing significantly to the systemic disruption and a virtual collapse of fixed income markets and liquidity. The preamble to the Reform Act stated the objective clearly, “to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency and competition in the credit rating agency industry.”

Despite that the now 14-year-old reforms to ensure higher integrity in the ratings process are still in effect, we are reading with concern that corporate credit has ballooned and complex securitized structures are in fashion again. Alarmingly, the discussion seems remarkably similar to the fall-out back in sub-prime days. This should signal to investors and regulators alike to be newly wary of the reliability of CRA ratings issued by nationally recognized statistical rating organizations (NRSROs). 

Is it true that issuers are back to getting multiple bids to do their ratings? Are they shopping for inflated opinions, just like the securitized packages of sub-prime debt back in the day? If so, we believe that authorities might want to tweak their oversight and perhaps check the NRSROs math. These are very complicated securities. Lots of judgement goes in the credit quality of a pool of loans in a collateralized loan obligation (CLO) structure.  

In a new twist that should not be discounted in its importance, interest rates are on lock-down by central banks around the globe. Credits that are normally much riskier can look less so given this environment. More concerning is a confluence of events. When viewed in combination with recent actions by the Federal Reserve to salvage repo liquidity, rolling back Volcker proprietary trading protections, and continued interest rate suppression, a potential return to sloppy credit rating practices is giving a lot of people flashbacks.

I would like to see some regulatory probing of “aggressive” ratings assigned to packages of loans that may reveal, upon deeper analysis, to be junk debt, even when mildly stressed against very modest and plausible rate increases. FSOC beware.   

When considered in a record-low rate environment with record corporate fixed income and a spike in BBB offerings, a huge slice of corporate credit comes to market as investment grade and is sitting on that precipice. And they should give regulators caution as to whether the intent of the Credit Rating Agency Reform Act is being honored by the credit rating agency industry. It was designed to deal specifically with the protection of investors and accountability of an important stakeholder in the integrity of our markets.  

Kurt Schacht, JD, CFA, is managing director of the Standards and Financial Market Integrity division at the CFA Institute.