Inflated Bond Ratings Helped Spur the Financial Crisis. They’re Back.

Times are tough for the Mall at Stonecrest in suburban Atlanta. The


closed in 2016. The


shut in 2018, and the Payless ShoeSource finished its going-out-of-business sale in May. When a $90.5 million mortgage came due last summer, the mall’s owners defaulted.

Through it all,

S&P Global

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has said a security tied to the mall’s mortgage wouldn’t lose money. S&P says the “situation is fluid” and “we won’t hesitate to revisit the rating.”

Inflated bond ratings were one cause of the financial crisis. A decade later, there is evidence they persist. In the hottest parts of the booming bond market, S&P and its competitors are giving increasingly optimistic ratings as they fight for market share.

All six main ratings firms have since 2012 changed some criteria for judging the riskiness of bonds in ways that were followed by jumps in market share, at least temporarily, a Wall Street Journal examination found. These firms compete with one another to rate the debt of borrowers, who pay for the ratings and have an incentive to pick rosier ones.

There are signs some investors are skeptical. Some bonds in markets where ratings criteria have been eased don’t trade at the high bond prices their ratings suggest they should. Investors have also shown skepticism about ratings on some corporate and government bonds.

“We don’t trust the ratings,” says Greg Michaud, director of real estate at Voya Investment Management, which holds $21 billion in commercial-real-estate debt.

The problem is particularly acute in the fast-growing market for “structured” debt—securities using pools of loans such as commercial and residential mortgages, student loans and other borrowings. The deals are carved into different slices, or “tranches,” each with varying risks and returns, which means rating firms are crucial to their creation.

The Journal analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019. The data, compiled by deal-tracker, allowed a direct comparison of grades issued by six firms: majors S&P,


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and Fitch Ratings, and three smaller firms that have challenged them since the financial crisis, DBRS Inc., Kroll Bond Rating Agency Inc. and


MORN -0.23%

The Journal’s analysis suggests a key regulatory remedy to improve rating quality—promoting competition—has backfired. The challengers tended to rate bonds higher than the major firms. Across most structured-finance segments, DBRS, Kroll and Morningstar were more likely to give higher grades than Moody’s, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.

“The victims are the investors,” says Marshall Glick, a portfolio manager at investment firm


LP. He was among a group of professional investors who in 2015 complained about inflated ratings to the Securities and Exchange Commission and asked the agency to make it harder for issuers to cherry-pick the best ones, internal SEC memos show.

The SEC didn’t implement their recommendations, multiple meeting participants say. Jessica Kane, director of the agency’s credit-rating division, declined to comment on the investors’ concerns, saying through a spokeswoman: “We encourage anyone with comments, recommendations or concerns to reach out to us.”

Rating firms say they don’t let business influence ratings. “Just having a higher or lower rating on a deal doesn’t make you more or less aggressive. It just either makes you wrong or right in the long run,” says Kunal Kapoor, chief executive officer of Morningstar, which acquired DBRS last month. “I stand behind our methodology.”

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Moody’s says “the regular adjustments we make to our models, methodologies and assumptions reflect evolving market conditions.” Fitch says “we are focused solely on getting the credit right.” S&P says “we compete on analytical excellence” and “no ratings business model is immune from potential conflicts of interest.” Kroll says that since its 2011 market entrance, “we have forced incumbent agencies to do better research and reexamine underserved sectors that they previously overlooked.”

After the financial crisis, ratings firms were criticized for taking lucrative fees and giving high grades to risky securities that caused big losses for investors. S&P paid $1.5 billion to resolve crisis-era litigation, admitting it set out to change rating models to benefit market share but not admitting wrongdoing. Moody’s settled for $864 million without admitting wrongdoing.

Top Grades

Moody’s and S&P have solidly outperformed the S&P 500 index since the financial crisis.

Share-price and index performance

Investor reliance on credit ratings has gone from “high to higher,” says Swedish economist Bo Becker, who co-wrote a study finding that in the $4.4 trillion U.S. bond-mutual-fund industry, 94% of rules governing investments made direct or indirect references to ratings in 2017, versus 90% in 2010.

Strong bond issuance and a rebound in the lucrative structured-securities market have brought good times back to the rating industry. SEC disclosures show fees for rating structured deals can top $1 million. Industry revenue rose 20% to $7.1 billion in 2017 from 2016, the most recent SEC data show. S&P’s and Moody’s shares are up more than eightfold in the past decade, and their stocks hit all-time highs last week.

Two fast-growing structured-bond sectors are commercial mortgage-backed securities, or CMBS, and collateralized loan obligations, or CLOs. CMBS fund deals for hotels, shopping malls and the like. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts.

In a May speech, Federal Reserve Chairman Jerome Powell compared CLOs to precrisis mortgage-backed debt: “Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards.”

Systemic flaw

Behind the ratings inflation is a long-acknowledged flaw Washington didn’t fix: Entities that issue bonds—state and local governments, hotel and mall financiers, companies—also pay for their ratings. Issuers have incentive to hire the most lenient rating firm, because interest payments are lower on higher-rated bonds. Increased competition lets issuers more easily shop around for the best outcome.

The Four Seasons Resort Maui at Wailea, owned by billionaire Michael Dell and featuring oceanfront suites that can go for $14,500 a night, borrowed more and won higher ratings. In 2014, the hotel’s investment bankers hired Morningstar to rate a $350 million bond sale backed by the property’s mortgage. Morningstar gave ratings to six slices of the debt that ranged from triple-A, expected to withstand the Great Depression, down 14 rungs to single-B, susceptible to losses in a mild recession.

When the resort refinanced its debt in 2017 in a $469 million deal, bankers picked DBRS as one of two firms to rate the debt. DBRS had just loosened its standards for such “single-asset” commercial-mortgage deals. DBRS issued grades as much as three rungs higher on comparable slices rated by Morningstar in 2014.

The Four Seasons Resort Maui at Wailea borrowed more and got higher ratings.



DBRS’s market share doubled to 26% within months of the change, according to industry publication Commercial Mortgage Alert.

Morningstar in June 2018 revamped its methodology for these deals, and its market share swiftly rebounded. It was one of two firms the Maui hotel’s bankers picked to rate its next offering, a 2019 deal for $650 million. While the hotel’s income had grown since 2014, the debt increase meant various slices of the offering had less cash available to repay investors than in 2014. Morningstar issued grades as much as two rungs higher on comparable slices rated by DBRS in 2017.

That should have lowered borrowing costs. Instead, investors demanded yields above where

Goldman Sachs Group



PLC investment bankers had initially hoped to sell the debt, say people familiar with the pricing.

DBRS referred inquiries to Morningstar, which says its Maui ratings partly reflected improvements at the resort and that the two firm’s methodology changes were meant to provide “greater transparency” to investors. A spokesman from Mr. Dell’s investment office referred queries to Goldman and Barclays.

Goldman referred reporters to a bond-offering document, pointing out disclosures saying bankers solicited “preliminary feedback” from six rating firms and hired two based on the size of their triple-A slices.

Another section of the document, which Goldman didn’t point out, warned investors they shouldn’t rely on ratings because “the recent credit crisis” showed their grades “were not, in all cases, correct.”

Rating analysts say their firms have lost deals because they wouldn’t provide the desired ratings. “I suppose that’s the flip side, isn’t it, of having more competition among rating agencies?” Huxley Somerville, a senior Fitch Ratings analyst, said in June after Fitch lost to another agency on rating a mall deal.

‘Incentives are wrong’

In the first half of 2015, S&P’s share of ratings in the $600 billion CLO market hit a five-year low, at 36%, according to data from industry publication Asset-Backed Alert, an affiliate of Commercial Mortgage Alert. That fall, S&P changed its methodology to make it easier for CLOs to get higher ratings. S&P rated 43% of debt in that market in the second half of 2015. In 2018, its market share hit 48%, still trailing Moody’s and Fitch. (Bonds can get more than one rating, so market share can total over 100%.)

When S&P again proposed loosening its criteria this year, a group representing more than 100 professional bond investors wrote a letter to the company, reviewed by the Journal, saying the changes “will lead to a weakening of credit protection for investors at a time where we need it most.”

S&P proceeded. It says the changes “take into account the evolution of the CLO market over the past decade.”

David Jacob, who joined S&P in 2008 to head its structured-finance sector, says he ran monthly reports explaining to his boss why S&P wasn’t selected to rate deals. The answer was almost always that its criteria were tougher than another’s.

“Little by little it weakens,” says Mr. Jacob, who lost his job in a reorganization in 2012 and is retired. “If you have the tightest criteria, who’s going to use you?…The incentives are wrong. They stayed wrong.”

Investors say ratings inflation is most evident in commercial-mortgage-backed securities, or CMBS, of which investors hold about $1.2 trillion. The Journal found DBRS rated these bonds higher than S&P, Moody’s or Fitch 39%, 21% and 30% of the time, respectively. It rated bonds lower 7% of the time or less. Morningstar rated the bonds higher than the big firms at least 36% of the time and lower 2% to 8% of the time. Kroll showed similar trends.

When rating a security higher than their three big competitors, Morningstar, Kroll and DBRS were around two rungs more generous, on average. Some ratings were a dozen or more rungs higher, potentially the difference between junk bonds and triple-A.

A spokeswoman for Kroll and spokesman for Morningstar, which now owns DBRS, said there is a bias in the data because when smaller firms put forth more conservative feedback on where they might rate deals, they are often not chosen to rate them. DBRS and Morningstar say that if these unpublished ratings could be reflected in the data, the results might look different.

S&P and Moody’s were about as likely to rate the same debt higher or lower compared with one another. Fitch showed a slight tendency to rate higher more often. Moody’s and S&P declined to comment on the Journal’s analysis. Fitch says “diversity in credit views is a positive for investors” who are “aware of the differences between rating agency criteria and make informed investment decisions accordingly.”

Moody’s, S&P and Fitch responded to increased competition by issuing higher ratings, according to two academics’ study of 2,488 securities rated between 2009 and 2014. One author, Colorado State University Finance Professor Sean Flynn, says “competition among credit-rating firms has, if anything, reduced the quality of credit ratings.”

In October 2015, Moody’s eased its rating methodology for single-asset CMBS deals like the one in Maui. Moody’s change led to upgrades of up to four rungs on some slices of about half of single-asset deals it rated. Its market share rose to 54% in the first half of 2016 from 28% during the second half of 2015, according to Commercial Mortgage Alert.

Fitch saw similar growth in another corner of the CMBS market in 2016 after giving itself wider latitude to use easier rating assumptions. The firm was hired on every multi-borrower CMBS deal in the second half of 2016, up from 80% market share during the second half of 2015. Fitch says: “This new criteria merely aimed to better reflect what we do.”

Moody’s ratings on riskier slices of these multi-borrower deals often weren’t as favorable as those of its competitors. By 2015, issuers “essentially stopped soliciting our ratings” on those slices, according to a January commentary from the company.

Inside the Mall at Stonecrest, whose owners defaulted on a $90.5 million mortgage that came due last summer.


Dustin Chambers FOR THE Wall Street JOURNAL

Investors demanded higher yields on triple-B portions of deals without Moody’s ratings than on triple-B slices that included Moody’s during 2011 to 2014, according to a Journal analysis of Commercial Mortgage Alert data. The difference was about three-tenths of a percentage point more, on average, than benchmark triple-B rated CMBS—which means it was costlier to borrow than comparably rated debt.

Adam Hayden, who manages a $13 billion securities portfolio at New York Life Insurance Co.’s real-estate-investment arm, was among the investors who met with the SEC in 2015. He said inflated ratings were a risk to market stability, according to a meeting memo obtained by the Journal.

The portfolio he manages holds about $10 million of a security called BACM 2005-1 Class B—the bond backed by the Mall at Stonecrest mortgage. When sold in 2005, the bond contained around 140 mortgages and earned high grades. As mortgages were paid off, the debt pool shrank. Stonecrest’s mortgage now accounts for 97% of the bond, according to commercial mortgage tracker Trepp LLC.

S&P downgraded the bond three times, keeping it at investment grade despite the default. Fitch in April downgraded the bond deep into junk territory citing “increased loss expectations.”

Inside the mall, next to the former Payless ShoeSource, sits a storefront that until this spring housed a bookstore owned by Monique Hall. Sales were so weak she filed for bankruptcy, she says. “This particular mall,” she says, “is on life support.”

Craig Delasin, CEO of the mall’s management company, Urban Retail Properties, says owners are finalizing a deal to extend the loan’s maturity and that the mall is signing up new tenants.

Stonecrest Mayor Jason Lary in 2017 made an unsuccessful effort to attract

’s new headquarters by offering to rename part of the city Amazon, Ga. He compares himself to a physician trying to help a sick patient. His prognosis for the mall: “a 50-50 chance of survival.”

Stonecrest Mayor Jason Lary gives the mall ‘a 50-50 chance of survival.’


Dustin Chambers FOR THE Wall Street JOURNAL

Write to Cezary Podkul at and Gunjan Banerji at

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