I’ve Seen This Movie Before

When a financial market sector is doing well on Wall Street, you can be sure that it will get exploited until it breaks.

One of the ways this happens is through “ratings shopping.”  If one rating agency holds tougher standards, the dealers will go to the others.  If the product is wanted by enough buyers, the credit and disclosure standards begin to slip for the whole market. Lenders, rating agencies or investors who insist on higher standards are basically forced out of business.

In Finance Monsters, I did give the Rating Agencies a partial defense for their ratings on subprime bonds, but the news this week is indefensible. Today the SEC announced a settlement with Standard & Poor’s regarding their ratings on CMBS (Commercial Mortgage-Backed Securities) in 2011. They will be paying $77 million to the SEC and two state Attorneys General, and will also be suspended from rating the largest part of the CMBS market for a year.

2011?  Are you kidding me? By my recollection, in 2011 the “peasants” were still outside the doors of the Rating Agencies with pitchforks and torches, calling for blood after the global financial crisis.

If this news weren’t enough to conclude that the market pushes the limits until they break, another piece of news on the CMBS ratings front came out that told us ratings shopping is alive and well today.  If anything, it’s stronger than it was in 2011 when some people at S&P felt they had to ignore their standards to stay competitive.

Jody Shenn summarized the situation nicely in the lead paragraph of his article on changes to the MarkIt CMBX index criteria yesterday:

“The practice of shopping around for the best ratings became so prevalent last year among issuers of U.S. commercial-mortgage-backed securities that a key set of indexes has been amended to accept grades from a wider number of firms.”

To summarize what has happened, issuers and Wall Street dealers have basically played the rating agencies against one another, and stopped using and paying fees to ratings agencies that wouldn’t be as “flexible” as others.  So much so, in fact, that many of the larger deals Markit would like to include in their benchmark CDS indices (known as the CMBX) have a number of bond classes that are only rated by one of the “big 3” rating agencies, getting their second ratings from smaller upstart agencies.

To no one’s surprise, the commercial mortgage loans in 2014 CMBS deals referenced in the latest CMBX index from Markit are objectively “worse” than the loans in the CMBX index covering deals from a year earlier:

“The share of loans backing CMBS included in the latest CMBX indexes with pro forma underwriting, or lender assessments based on projected increases in property incomes, climbed to 15.7 percent from 9.1 percent, according to Barclays. The amount of mortgages with loan-to-value ratios above 70 percent climbed to 31 percent from 20 percent. “

Those are just the facts that are disclosed.  Of course, investors can’t and don’t know everything about every property. Just in case it isn’t totally clear, that pro forma underwriting is the commercial mortgage equivalent of stated income lending in residential mortgages before the meltdown.

Can somebody please explain to me the persistent belief that free markets correct themselves before causing widespread harm, even to non-participants in those markets?  Do we really need to find out again that “free” markets tend to oscillate out of control, especially when the fundamental assumption that all market participants have all relevant information is never true?


2 Responses to I’ve Seen This Movie Before

  1. Doug says:

    Free markets do correct themselves, but this has been anything but a “free market” for some time. When the Fed artificially holds rates extremely low for extended periods of time and adds in massive amounts of QE, the economy becomes artificial, not free. The extensive influx of nearly free cash has people investing beyond their normal bounds just to get the money out.

    It is sad that our most powerful bankers didn’t learn this lesson the first time and seem insistent to repeat it. They seem fixated on the growth of the economy and not the health of the economy, which are two completely different things. China has shown us the growth is not directly correlated to health. Yet, we seem to be following the same path… borrow and spend government, nearly free capital, and a focus on quantity instead of quality, all of that leads to unrealistic markets.

    Investors are not attempting to get real market returns, they are only trying to achieve some minimal spread over artificially repressed cost of capital rates. Without the artificially low rates, the public would be demanding higher returns and more security (hence why much of the private investors sat on the sidelines for so long).

    With respect to rating agencies, most industry fix such problems by creating industry standards. I don’t believe that they have industry standards by asset type, but I could be wrong on that. With industry standards, then the competition becomes based on their fees and quality of due diligence. If there is no industry standard, perhaps there is an opportunity to start one?

    Would like to hear your opinions on those thoughts.

    • hhill51 says:

      Hi, Doug….

      Sorry about taking so long to reply. As you can see from my latest post, reality intervened in the form of leaking ceilings, damaged plaster, and “stuff” to move and dry out.

      You raise several interesting topics in your comment, so I may even take them as starting points for future posts.

      Regarding the zero interest rate policies, I think that was the central bankers’ way to recapitalize the banks at the expense of savers.

      Let’s not kid ourselves about central banks, after all. They exist, first and foremost, to protect their banking systems. All that stuff about inflation and employment is a happy fairy tale. If your job was to oversee and “guide” your national banking system, and you had spent an intense career getting to that position, wouldn’t you also think the most important thing in your world is the health of the banks you regulate? That’s even without the “ownership” structure of the Fed, BoJ, BofE, Bundesbank or ECB. It would be the one thing you would never question — that your banks must be sound or your world would come to an end as you knew it.

      More on “free” markets and rating agencies later.

      Thanks for the thoughtful comment.


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