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.
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.