The market is the loser in the ratings agency war
Standard & Poor’s has tweaked its corporate loan recovery ratings, indirectly affecting CLO recovery value tests and prompting managers to consider returning to the agency after moving to Moody’s. What a coincidence…
Let’s look at the context. Moody’s last year overtook S&P as the leading ratings agency for CLOs.
One reason for this was because S&P’s recovery ratings — which are used in CLO tests to determine recovery values — were seen as unfairly punitive. And with the rise of more aggressive like cov-lite loans, and their increasing use in CLO portfolios, managers were able to put more leverage on their deals if they used Moody’s.
So, naturally, managers did turn to Moody’s, which became the leading ratings agency for CLOs. As one market participant put it to GlobalCapital, S&P “took a pounding”.
Now, to cut a long story short, S&P’s corporate debt ratings team has changed the way recovery ratings are presented, splitting each recovery rating into two bands.
But the changes might also enable managers to put more leverage on new CLOs, or old deals if they are prepared to amend the documentation (conveniently, many managers are changing docs to meet the Volcker rule). The changes might also lead to a modest reduction in the credit enhancement required to reach a triple-A rating for new CLOs.
CLO market participants speaking with GlobalCapital say the change will “certainly” lead to more managers using S&P. One manager told GlobalCapital he would now consider using the firm for his next deal, having opted for Moody’s last time round specifically because of S&P’s recovery ratings.
“The recovery rating meant you were picking assets based on the recovery rating rather than the ones you really wanted,” he said. “We’ll definitely look at them next time – but if they hadn’t made this change we wouldn’t even be considering them.”
Not so, said an S&P spokesperson: “Analytic independence has always been a core principle of S&P's ratings process. We have long had policies in place to separate analytic and commercial activities.”
GlobalCapital has no reason to doubt this, but the chronology of events does not inspire confidence. S&P endured a lot of grumbling from the market and lost a bunch of fees over its policy on recovery ratings. Later, it changed the policy, which it says is in the pursuit of ‘additional granularity’.
The S&P spokesperson pointed out that no changes have been made to the assumptions used to rate corporate debt. It is just a tweak to how the information is presented. Certainly no direct changes have been made to the CLO rating methodology. But the agency has clearly listened to the market — the same CLO manager said S&P called him six months ago to talk specifically about the corporate debt recovery rating.
S&P may well have made the change free of any commercial pressure. But the moves in market share, and the change in criteria, are uncomfortably reminiscent of the pre-crisis behaviour which led to rating agencies being pilloried by the public and their regulators, and which landed S&P with a raft of lawsuits.
If it looks like S&P is weakening its criteria to recapture market share, market participants will draw their own conclusions, however robust the agency's "analytical independence". The agency needs to prove its integrity, or the market will be the real loser.