How Ratings Agencies Inflate Credit Ratings to Get Deals & Fees

How Ratings Agencies Inflate Credit Ratings to Get Deals & Fees by Wolf Richter for Wolf Street

This time, a new thingy, “Commercial-Real-Estate CLOs.” But investors don’t care because there will never be another default and they’re too busy chasing yield.

There is a fairly new and popular creature in the hopping party-town of securitizations: “commercial-real-estate Collateralized Loan Obligations.” These CLOs are bonds backed by risky commercial real-estate “transitional loans,” such as loans to fix up malls, dilapidated apartment buildings, and the like, with the hope that the property will then produce higher rental income. The loan is based on this hoped-for higher cash-flow. But that calculus might be wrong. And lenders want to off-load this risk. So they package the loans into commercial-real-estate CLOs.

Commercial-real-estate CLOs are a cross-breed between a regular Commercial Mortgage-Backed Security (CMBS), which is backed by mortgages on office towers, shopping malls, apartment buildings, student housing, and the like; and a CLO, which is backed by junk-rated corporate loans. So these commercial-real-estate CLOs are the riskier sisters of CMBS.

Banks that extend these types of risky commercial-real-estate transitional loans try to offload that risk to investors by securitizing these loans into highly-rated bonds that investment banks then sell to investors, mostly institutional investors such as pension funds.

Structured securities, including commercial-real-estate CLOs, have slices that take the first lost – the “credit enhancements” – and that carry the lowest credit rating. Investors in the higher-rated slices are protected by investors in the lower-rated slices that take the first loss. So the top slices can be rated triple-A, even if the debt that backs the security is very risky. The bigger the slices that take the first losses, the more protection investors have at the upper end. So far, so good.

The challenge for issuers is how to get a larger portion of these slices to sport investment-grade credit ratings, though by definition, this would thin the protection for these slices provided by the remaining lower-rated slices. The solution: Go shopping until you find the credit rating agency that promises the highest credit ratings.

Ratings agencies have responded to the competitive pressures by changing their criteria in rating commercial-real-estate CLOs in order to beat other ratings agencies and get the business.

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Wolf Richter

In his cynical, tongue-in-cheek manner, he muses on WOLF STREET about economic, business, and financial issues, Wall Street shenanigans, complex entanglements, and other things, debacles, and opportunities that catch his eye in the US, Europe, Japan, and occasionally China. WOLF STREET is the successor to his first platform… TP-Title-7-small-200px …whose ghastly name he finally abandoned in July 2014. Here’s the story on that. Wolf lives in San Francisco. He has over twenty years of C-level operations experience, including turnarounds and a VC-funded startup. He earned his BA and MBA in Texas and his MA in Oklahoma, worked in both states for years, including a decade as General Manager and COO of a large Ford dealership and its subsidiaries. But one day, he quit and went to France for seven weeks to open himself up to new possibilities, which degenerated into a life-altering three-year journey across 100 countries on all continents, much of it overland. And it almost swallowed him up.