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Rating agencies approach a crossroad in CMBS

By Max Adams
15 Sep 2015

Last month Moody’s Investors Service announced it would be taking comments on a proposal to loosen its criteria for rating single borrower CMBS. Let's hope this is not part of a ratings race to the bottom.

The move was criticised by some market observers as an attempt to gain market share in a corner of the CMBS universe that has been dominated by Standard and Poor’s and, more recently, Morningstar Credit Ratings. Moody’s position is that the historical default rate for CMBS backed by loans to a single borrower is low enough to support a move up in the loan-to-value ratio required for ratings throughout the capital stack.

It is reminiscent of a familiar debate: fierce competition among the rating agencies has the potential to negatively impact CMBS in the same way that lender competition has driven a general deterioration in credit standards. 

Earlier this month, GlobalCapital reported that investors are growing concerned that the market is headed towards a rating agency arms race that would enable issuers to push the loan underwriting envelope at a time many describe as a cyclical low in credit standards. The return of S&P to the conduit market at the beginning of 2016 — after a year long ban enforced by the Securities and Exchange Commission — will only heighten the competition among the agencies to win business from CMBS issuers. There is already talk in the investment community that issuers will be eager to bring S&P to the table as an alternative to Moody’s.

This should all ring a bell for anyone who was around in the last cycle. Rating agencies and issuers both insist that cries of ratings shopping — the issuer practice of awarding business to the agency that gives a deal the most attractive ratings that facilitated the market’s meltdown during the credit crisis — are unfounded, but investors aren’t entirely convinced. During S&P’s ban, the practice of excluding the agencies perceived as more conservative from rating the mezzanine and junior bonds became more widely used among CMBS issuers. Investors penalised these deals with wider pricing at issuance, but the practice continues. 

According to Morgan Stanley research, deals issued without a major rating agency down the entire capital stack are on the rise. Through August 2015, Moody’s has not rated a deal below the double-A class, the Morgan Stanley data shows. Fitch is also increasingly being cut out of the process, having been left off of 18 of 33 deals through July of this year. This combination of aggressive underwriting from the conduits and increasing competition among rating agencies has the potential to introduce a new level of uncertainty and volatility into the CMBS market.

Investors have done what they can to speak with their wallets and have demanded wider spreads for deals without a Fitch or Moody’s rating, while rewarding issuers who tap Fitch or Moody’s to rate their deals. For deals issued between March and July of this year, the difference in pricing between deals with a major rating agency stamp versus those without is 2bp for triple-A, 5bp for the AS class, 10bp for double-A, 17bp for single-A, and 19bp for triple-B minus, according to Morgan Stanley data.

The most recent trio of conduit deals this week does include stamps from either Fitch or Moody’s on all investment grade classes, and can be viewed as a “tacit acknowledgement from issuers that they recognise the fact that investors view deals with a major rating agency on all classes to be worth paying tighter spreads for”, Bank of America Merrill Lynch CMBS analysts wrote.   

The point of this discussion is this: while it is acknowledged that these businesses are striving to capture more of the market for rating CMBS, and while investors should take a look back at the last cycle and realise there is no real replacement for doing one’s own due diligence, the rating agencies themselves must also stand firm. It should also reignite at least some discussion around rating agency reform and changing the issuer pay model.

In this heated market, the rating agencies can either draw a line in the sand and agree not to repeat the mistakes of 2008, or they are doomed to repeat the mistakes of their past. 

By Max Adams
15 Sep 2015