This time, a new thingy, “Commercial-Real-Estate CLOs.” But investors don’t care because they’re too busy chasing yield.
By Wolf Richter for WOLF STREET.
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.
And the business is booming. In 2019, banks offloaded $21.4 billion of commercial-real estate CLOs to investors, up from less than $1 billion in 2012, according to the Wall Street Journal, citing data from TREPP, which tracks CMBS.
The ratings agencies that most actively compete to rate these commercial-real-estate CLOs are Kroll Bond Rating Agency, DBRS Morningstar (after Morningstar acquired DBRS in June this year), and Moody’s. They get paid by the issuer of the bonds. And the issuers want the highest ratings on the biggest portion of the bonds.
That’s where the shopping starts. According to the WSJ, banks approach the ratings agencies with a specific deal. The ratings agencies then provide “initial feedback” on how they would rate the bonds, and banks can see which agency would provide the highest credit ratings, and they hire the firms then based on that feedback.
To get more of this business, two of the rating agencies have changed the criteria of rating commercial-real-estate CLOs.
Kroll changed its criteria in 2017. The WSJ:
A comparison of Kroll’s old methodology and its new one shows that the firm relaxed some rent and occupancy stress tests for mortgages financing multifamily apartment buildings – a big part of the market for these loans. That could yield higher ratings, according to current and former ratings analysts.
DBRS, after having been leapfrogged, changed its criteria in March 2019. The WSJ:
The change included a new ratings model that assigns a lower probability of default to multifamily versus other property types, according to Erin Stafford, DBRS’s head of North American commercial mortgage-backed securities analysis. She said the new model was implemented because of its higher predictive power, not due to commercial considerations.
“This is hauntingly familiar of legacy agency behavior precrisis,” the head of Kroll’s real-estate group, Eric Thompson, told the Commercial Mortgage Alert in June, accusing DBRS of easing rating standards in order to get the business and the fees, after Kroll had itself changed the criteria in 2017.
Morningstar, after acquiring DBRS, said that DBRS Morningstar would use the new criteria of DBRS, which were, according to the WSJ, “generally considered less conservative than Morningstar’s.”
DBRS is a “learning organization” that updates its methodology to incorporate new data and analytical approaches, it told the WSJ. Other ratings agencies “presumably do the same.”
In other words, the race to the bottom is on. And this is how it works in practice, according to the WSJ: A real-estate lender shopped the three ratings agencies last spring to rate the eight slices of a commercial-real-estate CLO.
- Moody’s in its feedback to the lender said about half of the slices would be rated triple-A; it was hired to rate only one of the slices.
- Kroll in its feedback to the lender said about 61% of the slices would be rated triple-A; it was hired to rate “a handful” of slices.
- DBRS said in its feedback that two-thirds would be rated triple-A; it was hired to rate all eight slices.
DBRS’s victory came after it had changed its ratings criteria that then gave more slices the top rating, thereby thinning out the loss-absorption cushion for the triple-A rated slices.
And this ratings-shopping is standard industry practice. According to data from the Commercial Mortgage Alert, cited by the WSJ:
- In 2017, DBRS led the commercial-real-estate CLO ratings game with getting 10 of the 18 total deals.
- In 2018, Kroll won the game, by getting 21 of the 25 total deals; after having changed its criteria in 2017, in response to getting clobbered by DBRS that year.
- In 2019, since changing its criteria in March, DBRS got 16 of the 24 total deals. Kroll only got 9 deals.
One of the deals where DBRS won was a $650 million commercial-real-estate CLO sold by Arbor Realty Trust Inc. in May. Under its new criteria, DBRS issued investment-grade ratings on such a large portion of the CLO that a loss of only 14.5% of the underlying loans would eat through the loss-protection cushion; any additional losses would eat into the investment-grade slices. This is down from a loss-protection cushion of 21.5% on a similar deal by Arbor that DBRS rated in 2018 before it changed its criteria.
The commercial-real-estate CLO market is only a small segment of commercial-real-estate structured securities, but the pressures are the same: To beat other ratings agencies and get deals and the fees, ratings agencies offer higher ratings on riskier debts.
And everyone is happy. The ratings agencies that get the deal are happy because they’re getting the fees. The issuer is happy because the deal got more appealing credit ratings. And investors are happy because they were able to buy highly rated securities backed by risky commercial-real-estate transitional loans, which is a hot thingy, and they don’t really care about the thinning loss protection cushion since there is never ever going to be another default and because they’re too busy chasing yield.
Wow, that was fast: In default is a $650 million portion of a $2 billion commercial real estate loan package, signed in 2018. Read… Brick & Mortar Meltdown Manhattan Style: Lenders Foreclose on Times Square Tower whose Six Retail Floors are 90% Vacant
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Forgive my naïveté, but is there a buyer’s based rating service for these kinds of instruments? Individual investors or even small institutional investors won’t have the kind of wherewithal to delve into the details of these instruments. I got super lucky with some REITs in the 2000s but realize I just got lucky at the casino. Most of the properties associated with my hot gains have since collapsed.
PS: I think the 1031 exchange provisions of the US tax code are the major reason for the crazy swings in US commercial real estate. Either Wolf or one of the commenters has pointed out that the US has 3-4 times as many retail property footage compared to other industrialized counties.
Most of the properties associated with my hot gains have since collapsed.
You’re a real canary in the coal mine there, Press. Well, not you personally.
People could just pick the ones you wouldn’t touch, but that probably wouldn’t work either.
Is there some particular reason why PressGaneyMustDie? I’m sure it’s a good one. You didn’t pick this as a handle just so somebody would ask, did you?
Weiss Research used to be a credible source of info mainly on insurance companies. They called some significant failures years ago.
Unless the rating agencies are actually financially liable for inflated ratings and subsequent systemic destruction, there is no hope for accountability, as there are no consequences.
The major rating agencies all of the AAA investment grade derivatives during the last cycle, adding fuel to the impending fire. They do not underwrite, they just collect ever larger fees for window dressing.
There are plenty of credit analysis outfits out there that sell their work to their clients, and big investors have their own shops checking into the credits they’re interested in buying. But this type of research that needs to be sold to clients (so that these firms can make a living) cannot be made public because then it could no longer be sold.
The benefit (if it’s even a benefit) of issuer-paid credit ratings – such as the ones we’re talking about here – is that they become public, and everyone can use them and look at them.
Wolf,
Excellent as always.
Basically the same conflicted relationship that public corps have with their accountants – who they also select and pay (but who maybe have marginally more potential liability than the raters.)
And the fix is equally simple in both cases – a law requiring ratings, a fixed tax/fee system to pay for them, and mandatory random rotation of raters/accountants.
But apparently the US economy must blow its brains out a few more times before the obvious is allowed to become the inevitable.
I am more skeptical of investments after participating in markets for 30 years. Its not so different than buying a house before the bust. There are a lot of fee takers in the process and as a buyer of residential real estate you are probably the least informed person in the process. Its still up to you to make sure you don’t get screwed.
Wolf, if “The benefit…of issuer-paid credit ratings…is that they become public, and everyone can use them and look at them.” Do the big investors have access to the details of the supporting credit analyses? Or do they just get a collection of letters and +- symbols like we do.
Lisa_Hooker,
If you’re a paying subscriber to one or more services of S&P for example, you get to see a huge amount of detail, including the data that back their credit analysis. I had a deal with S&P a few years ago, Wolf Street being a media site, and they gave me free access to much of their data. And then one day I lapsed and said something somewhat critical of S&P with the term “conflict of interest” in it, which was the third rail, and two hours later they cut me off :-]
If I was Japanese or Taiwanese, I will read this article 3 times or more.
Then I will see all my CLOs.
I meant they will sell all their CLOs.
I personally don’t have any.
A retail investor, no matter the nationality, is unlikely to directly hold CLO’s of any kind.
This is stuff marketed to insurance companies, family wealth management, pension funds etc all financial entities that need any scrap of fixed yield they can get to keep their obligations.
The high rating is needed because many of the products these entities sell their customers have contractual obligations to be invested in “at least 30% AAA rated securities at any time” or similar clauses.
Now, I used to be invested in a family wealth mismanagement fund and at one point I became intrigued to learn why it performed so poorly at a time of financial market enthusiasm, so I requested a full quarterly report of their holdings.
A few days later I received in my (physical) mailbox a thick envelope containing a document running 38 pages in small print with the full details of what they were holding at the beginning of the quarter, what they were holding at the end and what they traded in between. It was very eye-opening to understand why the term “dumb money” is applied so liberally (and deservedly) to this kind of investors and why retail investors lose money even when financial markets are on the way up.
Suffice to say the mismanagement fund is long gone and replaced by dumb funds tracking several stock benchmarks. Lesson painfully learned, albeit it was not as humiliating as my Brazilian investments.
CLO’s are fine as part of many investment strategies, but only as long as they pay a yield (not a coupon) proportionate to the real risk they carry, and CLO’s tend to be backed by pools of debt of below-average quality.
Rating two thirds of the tranches in a CLO fund AAA means two things: either the fund manager is buying a lot of loans taken out by companies with excellent credit or something fishy went on during the rating procedure. Neither is a good sign.
Ratings agencies in full view of the Fed & SEC, so future bailouts are guaranteed. Bailouts are pre-orchestrated through progressively risky bond ratings. When Ma n Pa Pension holder gets dinged, Unka Sam MUST respond. This article is just highlighting Phase 1 (or 2 perhaps) of the bailout cycle. Yield chasers are fully protected.
I would be interested to know what yield these CLOs are paying – I may want to jump in !!
Really? In the next recession, we will see who will be saved. And I wonder who will buy the additional debt? With de-globalization, it might just be save yourself.
I wouldn’t be so sure … pension holders have been hit with benefit cuts plenty of times before. Private sector pensions get the worst of it, but public sector pensions occasionally trim benefits too.
Wow! This is amazing! Nothing like this has ever happened before. Okay, end of sarcasm. Who remembers when it was discussed at great length after the Great Recession started? And then we just forgot. And now it’s happening again. What a surprise. Oops, there’s more sarcasm.
Careful there Jeff. You’re going to burn out your sarcasm gland and then you’ll have to start taking these things seriously.
I had to get a cynicism gland transplant. I was on a waiting list for three years.
Fortunately for me, I’ve never had to undergo a cynicectopy. My cynic gland has functioned superbly since .. since 1971. Still kickin ….
“1971”
US off gold standard and DC’s era of Fiat f*ckery commences.
I was hoping to see a review of the Federal Reserve report finding that tariffs raised prices, cut employment and hurt US manufacturers.
Maybe later.
The ratings agencies then provide “initial feedback” on how they would rate the bonds, and banks can see which agency would provide the highest credit ratings, and they hire the firms then based on that feedback.
None dare call it securities fraud.
Are there any financial crimes still on the books that haven’t become dead letters? Short of just grabbing Granny’s saving account?
That is not a rhetorical question.
Personally I believe there’s only a few crimes left. Should these laws ever become inconvenient the addition of a few sentences by Congress, buried in any bill, will resolve the problem. Modifying a Mel Brooks quotation – “It’s good to be a congressman.”
And better yet to own some.
If the bank robs you, that’s legal now.
But it’s still illegal for you to rob the bank.
I suppose bank robbery is technically a financial crime so that makes two still on the list.
Except that grabbing Granny’s savings account is legal if you’re a hospital making up your own prices for everything, right?
As I was reading the article I thought of the Dominion Bond Rating Service, decades ago out of Toronto.
Looked it up and it is now the DBRS mentioned above.
Like most competitive businesses, rating agencies can “bid” for new accounts.
Which reminds of in Medieval times when entertainers would stay at a grand hall, trying not to lose their welcome. Food and a place to sleep for no money and hopefully tips.
Thus, the saying by traveling troubadors–“His bread I eat, his song I sing.”
In this case, it is providing a desirable rating. For fees.
Some 30 years ago I got to know one of the head guys at “Dominion” and we talked about down-grading during a contraction. And I asked the critical question, which was about making the down-grade to below Investment Grade.
They were very reluctant to push off the ultimate collapse of an issue.
They would rather make it after the obvious plunge in fate.
If he interest rate on your investment is lower than the rate of monetary expansion you are getting poorer.
. . . irregardless of the agency rating
hey, give me back my double negation!
Would you take a disalternate fact instead?
That is true. It is my understanding that the end result of Fed policy was to inflate asset prices which is another way to say reduce future cash flows from this point forward (yield on sp500 is now 1.7%). Might as well sit out in short term treasuries or CD’s and take a 1/2% loss each year until the party ends. Tesla reminds me a lot of Cisco Systems around 1998 – 99. Still hasn’t recovered peak price 20 years later.
Not quite. Have to normalize for population growth too.
S&P has testified in court that the ratings from financial ratings agencies (itself, in particular) are ‘puffery’, and should not be used as the basis of investments.
It seems that after that, any money manager who trusts ratings should be considered guilty of malfeasance.
But that’s not the way the game is played, is it.
For unamused,
I think they covered grabbing Granny’s savings account with Dodd-Frank no? This should cover re-appropriation of what is left of pensions, 401k’s, IRA’s, etc once the dust settles. The Sheeple will then have been thoroughly sheered.
Rating agencies, a/k/a, whores.
So… how long until at least one rating agency dies due to this?
I don’t buy bonds but if I did
I’d pass on new issues bs rating
but older bonds ratings should be ok
Anyone chasing yield (like Europeans and Japanese in a ZIRP/NIRP environment) will buy this junk because it has a decent rating. What could go wrong? This is the 2008 derivative mess all over again. Same hucksters, different suckers.
This subject is outside of my area of competency. I could make an educated guess.
If the debt instrument contains loans on multiple properties and partial interests in properties in different markets, it might be difficult for a buyer to assess the credit worthiness of the bundle of debt. Increasing complexity is used to baffle the naive.
In the movie The Big short, Steve carrel will go to a bonding agency to ask them why they rate the junk as AAA. The lady in-charge is blind from cataract surgery (literary allusion). She will simply say if we don’t rate it AAA, then they will go to other agencies. This is called “honor among thieves”. Rating agencies don’t snitch on the bonds, bonds don’t snitch on stocks and so on. Everyone is together on this one. Now, your article is like a tree falling on a forest. No body hears it. There is no sound. At some point of time, someone will say the truth in the main stream media.
I don’t do corporate bonds, but I will purchase individual stocks. You don’t own anything if the company can’t make its debt payment if you are a stockholder. I usually try to focus on one uncomplicated company and really read the SEC filings and review how the company did during the last recession. You can see debt level and cash flow history on free sights enough to figure out if the company is taking too much risk. I usually like companies that make or sell a tangible product as I can wrap my head around those easier than financial or business service companies.
That’s old school, but I guess that’s the point, isn’t it? The risk is that this isn’t an old-school market. You still need to look out for financial predators who might be tempted to make a ‘disruptive’ play which may affect any of the elements of your portfolio, directly or indirectly, or adverse changes in markets, or competitors, that sort of thing.
That said, it’s hard to go wrong in a bull market, and this one’s beyond manic, driven by NIRPZIRP, but at least your strategy keeps you away from a lot of the frenzy, and that’s good. You might not get richer faster, but you’re less likely to have a bullseye on your back.
OTOH, it’s hard to keep from losing when the market crashes, and your only salvation there is to guess right when it’s time to jump.
I’m not that tempted. Long or short, investing and speculation in financial markets amounts to a sort of parasitism regardless of your best intentions. That’s unlike putting your money in, for example, your buddies shop that’s doing well but could do more with extra space or better equipment.
Even in grass-roots investing it’s nearly impossible to avoid financialisation completely, but we ourselves continue to reduce our financial dependencies year by year. Discussion deferred.
The setup is just too juicy.
Yeah, but you still broke your vow. Fortunately you’re otherwise truly trustworthy, fortuitous, and all that, so the slight loss of confidence can easily be restored.
If it were me, I’d want to be careful I don’t start falling into old bad habits. I’m given to rationalisation and self-indulgence, and not very good at the ‘lead us not into temptation, but deliver us from evil’ thing. Lucky for you, you’re not me, but then again, hardly anybody is.
At the end of the day George Carlin said it best:
https://youtu.be/kXhZyAOuyhE
The biggest shame is that the average American taxpayer will be on the hook for the debacle just as we were in 2009…ask a senior who saved all their lives to retire with a simple Social Security payment and some additional investment income but with preservation of principal…Oh? What is 0% interest going to pay?
During 2019 we were “given” 2%+ yields on simple bank accounts. Far less than we were “promised” for decades. One year out of approximately the last ten. That was spendable interest income. Now it has been taken away again. Anyone else here feel disappointed in the “system?”
While at the same time the interest rate on credit cards was over 18% for most people…Big Banks…protected…
But interest rates for those same cards are 0% if they are paid off monthly. Living within your means has benefits.
And the FED will bail it out when it all crashes down. Nothing learned from 2007-2010 crash.
Dan:
“Nothing learned from 2007-2010 crash.”
Oh yes! We learned that it is better to be the crook than those the crookedness is perpetrated on!
Reading this article by Wolf just brings back so many memories of my research “back then” in this case the rating agencies and their machinations……..
Where is Stalin when we need him??????
Where is Stalin when we need him??????
I’d say he’s been in a communist plot since he went underground.
The nature of these projects suggests they have some government assistance, being redevelopment projects. The nature of these contracts would imply better covenants on lending, but not necessarily. The description smells a lot like ’eminent domain’. In that instance the government gets between the buyer and seller, private parties, for the purpose of creating better tax revenues. Are they setting up some muni governments for failure? Is that what happened in Jeff Co, ALA, when Goldman sliced and diced an overly ambitious waste water project?
A Happy and propitious New Year to all – and especially Wolf (and his shorting experiment).
It’s obvious we are all about to enter the Roaring Twenties (again). History tells us the last time they were a lot of fun. Personally, I desperately hope it does not end the same way, although I’m hard-pressed to see why they won’t.
Best Wishes to All for the coming New Year.
“And investors are happy because …they don’t really care about the thinning loss protection cushion since” THE MANAGERS HAVE MADE SURE THEIR PERSONAL COMPENSATION WILL NOT BE HARMED WHEN THE S**T HITS THE FAN.
There, fixed it for ya.
I distinctly remember an article, which I currently cannot find, that described the ratings process for mortgage CDO’s just before the great financial crisis. What it said was that CDO issuers paid lots of money to rating agencies, for a temporarily license of their CDO modeling tool, which determined what Credit Enhancement and CDO Tranche Structure was required by a pool of mortgage bonds in order to achieve a specific CDO Credit Rating. Here’s some information about S&P’s old CDO modeling tool:
https://www.globalcapital.com/article/k64wkt8jqx0z/standard-poors-cdo-evaluator
This meant that CDO issuers could manual manipulate these models, by trial and error, until their pool of mortgage bonds achieved a desired Credit Rating. After, there was a committee review by the rating agency to validate the models results. I’m pretty sure the article was somewhere in Bloomberg. Hope this is not how commercial real estate Collateralized Loan Obligations are now being rated.
Unfortunately it appears that S&P’s CDO evaluator is part of their current Collateralized Loan Obligation (CLO) ratings process:
https://www.youtube.com/watch?v=6xUNPmar7OA
And it offers the same potential for ratings manipulations that CDO managers once used. So this is part of how commercial real estate Collateralized Loan Obligations are being rated. What could possibly go wrong?
The code for the model assumed a positive growth percentage for the value of the assets. It was impossible to enter a negative growth rate. Because housing prices only go up. Wasn’t much trial and error either, they wrote scripts in Shell and Perl to feed the canned model and create mortgage packages.
DBRS (Dominion Bond Rating Service) born in Toronto. DBRS was acquired by the global financial services firm Morningstar in 2019 for approximately $700 million.
Canada has notoriously weak securities oversight, compliance, and legal consequences. The Vancouver Exchange was notorious for pump and dump schemes involving mining stocks. “Salting’ gold mines was a favourite trick.
Does anyone remember Bre-X Minerals, David Walsh, John Felderhof, and the estimates provided by a division of SNC Lavalin? SNC Lavalin was recently in the news as Conservatives blamed Trudeau for the crimes of their friends.
It seems to me that there are no consequences for bad bond ratings. In fact it appears as if it might be a positive thing as bond issuers know agencies will say anything to make a buck.
I know hardly anything about the opinions of rating agencies, but I imagine material facts and ‘CYA’ opinions aren’t prominent, but are buried deep in the report.
It appears as if many securities are based on vaporous connections to the underlying asset. A loan based on a property or business is a firm, first level connection to the asset. A ‘security’ based on some collection of these assets is obscure, and probably such is the intension. Allowing further ‘securitization’ of second level ‘securities’, derivatives, or the addition of insurance, is madness as the 2008 Financial Crisis amply demonstrated. These things float on bullshit and attitude not any connection to the underlying asset.
Ensuring the rating agency, accounting firm, and investment advisor states the material facts and opinions as preamble to the rating would be a good start. Including unfavourable opinions by others and providing rebuttal should also be a requirement. Including the past history of the issuing firm and officers should be a transparency requirement.
Require the SEC, and other national compliance agencies, review the preamble for clear language and comprehensive presentation of fact, at the cost of the issuer and rating agency. It should be the SEC’s responsibility to rate the bond rating agencies, issuing firms and officers business history, and compliance with legal requirements.
Vaporous ‘securities’ are a direct consequence of ‘limited liability’ and ‘caveat emptor’. Removing these defences when it has been proven that the ‘opinion’ was the result of blind incompetence, criminal conspiracy, failure to acknowledge material fact, or failure to conduct due diligence. Then liquidate the assets of board members, past and present, corporate officers, senior management, pension funds, of the issuing company and rating service. Make anyone who sells the bonds personally liable to their clients for the full value of the bonds.
If someone does, or should, know the bond is weaker than the rating states. and says nothing, then they lose everything, publicly, including the right to be trusted in any future business venture.
The old one about analysts applies to ratings – in a bull market you don’t need them and in a bear market you don’t need them.
What spooked me in this article is that Morningstar has gotten into the bond-rating business via DBRS. That says tons of bad things about Morningstar and makes any of their other ratings “products” suspect as well.
You have to do your own homework in finance. The Wall Street line is “If you want a friend, get a dog.”