The Fledgling Conflicts Of Interest At The Nouveau Rating Agencies

A lot has been said recently over the much-maligned traditional rating agencies: S&P and Moody's. The rampant conflicts of interest over the past decade which everyone on Wall Street was all too aware of, somehow were a shock to politicians such as Barney Frank. In fact these very conflicts have been proposed to be the root of the credit and mortgage crisis (one can see how that is not a futile argument: if an excel workbook crashes your PC if you try to assume declining housing prices someone should have raised a red flag somewhere). Of course, that is a naive conclusion but not entirely without merit. In fact, odds are that the next time the market swoons by 40-60%, Barney Frank will refocus populist anger at exactly these rating agencies which have so far managed to escape relatively unscathed.

But the crucifixion clouds are gathering.

The administration realizes that the only purpose for keeping rating agencies alive is to promote the AAA fallacy which is necessary for TALF inclusion. Of course, TALF is critical to make sure when the CRE debt rollover occurs, there is some method of securitization (hopefully an improvement on the abject failure that the first round of TALF CRE bids proved to be). However with recent overtures by the likes of S&P which indicated it would downgrade approximately 80% of all existing CMBS classes, the "rating agency issue" quickly became the weakest link in the administration's plan for CRE bail out. The solution: quickly add many new redundant rating agencies in order to neutralize a legacy player getting a "conscience attack" in the middle of the biggest CRE rescue operation ever attempted. This explains why companies such as Realpoint and DBRS were recently added to the roster of Nationally Recognized Statistical Rating Organizations (NRSROs). It also explains why CRE cash flow modelling specialist TREPP was retained by the NY Fed as a collateral monitor. But with new expansion, comes new diligence (or lack thereof) and new conflicts of interest that the administration will claim are not an issue... until it is too late.

In a piece focusing on some these "nouveau" entrants, Anonymous Banker takes a long hard look at TREPP. His observation:

How many Commercial Mortgages will Chase Bank be allowed to unload through TALF, a government program that has hired as its collateral monitor Trepp LLC whose UK Parent company utilizes, as their stockbroker, a company that is owned 50% by JP Morgan Chase.

Does anyone else see this as a conflict of interest?

While the TREPP conflict is somewhat moderate, Zero Hedge applauds this fact finding effort as pointing out the truth behind the scenes will make its potential abuse that more problematic (but unlikely to stop it). Furthermore, TREPP will not have direct say in actual ratings - merely advise the Fed on whether or not to make unique exclusions (which they will of course do regardless, as suits their particular interest).

Zero Hedge was impressed by Anonymous Banker's ambitious plan to unearth potential conflicts of interest within the new rating agencies, and after doing a little diligence, we promptly stumbled upon one of our own, this one involving not a NY Fed puppet such as TREPP, but an actual TALF-primed rating agency: RealPoint.

Curiously, when RealPoint applied to become a NRSRO in 2008, the Horsham, PA firm disclosed to the Securities and Exchange Commission that it had a pre-existing conflict that would automatically bar it from being an NRSRO absent an exemption granted by the SEC:

Realpoint LLC (‘‘Realpoint’’), a credit rating agency, furnished to the Commission an application for registration as an NRSRO under Section 15E of the Exchange Act for the class of credit ratings described in clause (iv) of Section 3(a)(62)(B) of the Exchange Act.4 Based on the information provided in the application, Realpoint has a conflict of interest that would cause the firm to be in violation of Rule 17g–5(c)(1) if Realpoint became registered.

Specifically, for the fiscal year ending December 31, 2007, Realpoint maintained credit ratings solicited by a person that provided Realpoint with 10% or more of its total net revenue for that year.

Realpoint has requested that the Commission exempt it from Rule 17g–5(c)(1) for the fiscal year ending December 31, 2007 on the grounds that the prohibition hinders its ability as a small entity to further develop its business issuing credit ratings on assetbacked securities. Realpoint also stated that it expects the percentage of net revenue attributable to the relevant client to decrease to approximately 7.5% of its fiscal year 2008 net revenue.

Odd - is this the same RealPoint whose CEO a little over a month ago was pitching the completely conflict free nature of his business model to none other than the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Financial Services Committee of the U.S. House Of Representatives, and I quote:

The principal difference [from our business model], of course, is that the larger firms such as Moody’s, S&P and Fitch are now issuer-paid rating agencies. As such, they are paid substantial, up-front fees on the sales event by the corporations which are issuing the securities or by investment banking companies which are underwriting the transaction. Another major difference is that our monthly reports provide ongoing surveillance of the CMBS real estate securities, properties, loans and markets.

Strange that a completely conflict free organization would need SEC exemption from Rule 17g–5(c)(1): the existence of one client, soliciting raings and generating over 10% of revenue - one of the most basic and logical preventions of revenue generational bias. And while not a topic of this discussion, the speed with which the "fair market regulator" SEC granted RealPoint an exemption (a mere 2 months from the date CEO Dobilas demanded a NRSRO status) is simply staggering for an organization that takes about half a year to find out which of its employees had traded on insider information.

What is, however, a topic here, and what will be the next FOIA request that Zero Hedge submits, this time to the Securities and Exchange Commission itself, is just who this "person" was, that had solicited extensive RealPoint ratings in 2007 and 2008 and thus may have had an "unwitting" ability to enforce a ratings bias in this NRSRO that had previously been considered free of all potential conflicts. While we do have our reasons to suspect that a big three CRE focused bank (DB, JPM and GS) may have been the perpetrator of this RealPoint revenue generosity, we will know for a fact once we receive a response to our FOIA request (we do not anticipate this to be a sensitive national security issue and thus hope to get a response from the SEC in as brief a time period as it took the SEC to exempt RealPoint).

To clarify - if indeed it turns out to be one of the three aforementioned firms, it would set a dangerous precedent where a major investment bank with hundred of billions of CRE exposure has the potential to (and did so in the past) influence the rating agency that has displaced a Standard & Poors which may or may not have recently found god (the big CRE downgrade is still pending - still not too late for one of Steve Rattner's legendary persuasive phone calls).

Of course, we hope that the FOIA request ends up uncovering nothing substantial. However, as long as rating agencies stand to benefit from subjective "AAA" opinions in the $ trillion + TALF market at the behest of their much bigger investment banking... pardon... bank holding company peers, the possibility for a repeat of the chain of events that led us to the current post bubble predicament, compliment of Moody's and S&P, is surprisingly high.

What is even more bothersome is the eagerness with which the nation's main regulator is willing to be pushed over in protecting the aforementioned critical Rule established decades ago (actually about the time the 3rd bear market rally of the Great Depression was rolling over) to prevent just such conflicts of interest; in fact it makes us think that adding some additional disclosure requests to the FOIA may not be a bad idea: such as, for example, was someone in the current of previous administration, or any current or previous bank executive involved in the "decision making" process of whether and why to grant RealPoint the desired exemption.

Disclosure: big fans of RealPoint and TREPP software and analytical products, not fans of putting AAA where a B- is more than warranted.

Sphere: Related Content

Bookmark this post with:

• 
• 
• 
• 
• 
• 
• 
• 
• 

Fed Starting To Panic Over TALF Collateral Concerns

The Federal Reserve of New York is apparently just now realizing that Commercial Real Estate collateral is more than just wishful thinking. In a press release issued earlier, the NY Fed announced that it had picked TREPP to serve as a collateral monitor for the CRE Hail Mary pass better known as TALF. One would have expected the Fed to actually have some sort of algorithmic modeling of CMBS cash flow projections before it had decided to dedicate $1 trillion to this neutron bombed segment. Of course, always better late than never. From the press release:

The TALF is designed to increase credit availability and support economic activity in part by facilitating renewed issuance of consumer and business asset-backed securities (ABS) and CMBS. Trepp is an established provider of information and analytic services to the CMBS and commercial mortgage finance industries. As a collateral monitor for the newly issued and legacy CMBS assets, Trepp will assist the New York Fed by providing valuation, modeling, analytics and reporting, as well as advising on these matters. Trepp will not establish policies or make decisions for the New York Fed, including decisions whether to reject a CMBS as collateral for a TALF loan or exclude loans from mortgage pools.

I may be rusty, but last time I used TREPP, it told me the CMBS market was overoptimistic by about 1,000 bps. And that was when AAA spreads were at 1,000. One would hope not too many tweaks occur to the TREPP engine as it is "ported" over to the Fed: in that case there may be some hope that Dudley, Geithner et al, realize just how massive cumulative losses will be on all sorts of vintages and classes and will finally abandon the zany TALF plan altogether. Or if not, as Wall Street Pro says, perhaps they will let the taxpayer put the last dollar in to the TALF purchase (displacing the 12x leveraged chunk from various hedge funds), and allow them to actually pocket the upside instead of just footing the downside.

hat tip Rob Sphere: Related Content

Bookmark this post with:

• 
• 
• 
• 
• 
• 
• 
• 
• 

The "Special Servicing" Problem

Following up on a post from a few days ago in which the general skyrocketing of delinquencies was observed, today I present an overview of some of the largest properties and loans that have recently been put into that very unenviable category of "special servicing." According to Trepp, in April a record $4.4 billion in loans were transferred to special servicers, bringing the total to $23.8 billion. Transfers occur when master servicers hand off loans to special servicers once they notice signs of trouble. Special servicers then attempt to work out the problem with the borrower and return the loan to normal status or negotiate a payoff. If that approach fails, the loan is liquidated and the proceeds are forwarded to bondholders.

Manus Clancy of Trepp had the following green shoots dousing words to say about the current environment: "People are starting to talk about the economy bottoming out, but commercial real estate seems to be lagging the rest of the economy - we're seeing an acceleration in problems. April was worse than March, and March was worse than February. There's cause for concern that each month is getting worse."

In terms of specific segments within CRE, the most pain is still seen in the multi-apartment properties. Loans on multi-family complexes account for 15.2% of the total balance of outstanding CMBS transactions, their share of the special-servicing units is more than twice as high: 32.3%. On the other hand, office mortgages are the slowest to react to a deteriorating market, and are underrepresented in the special-servicing pool. Their share is 17.1%, versus 30.1 % in the overall CMBS universe. This is primarily due to the longer-dated nature of office leases and the corporate backing behind contracts: it would not look good if Fortune 500 companies made financial blogs with disclosure that they were in dire need of lease renegotiation. However, all this means is that the pain in office properties (and especially for office-focused REITs) will be that much more pronounced once the bottom really falls of the office rent market within the next year.

As an indication of some of the larger loans in special servicing, I present the following chart which breaks down the key properties by segment and by entry date into special servicing.



hat tip A B and Trepp Sphere: Related Content

Bookmark this post with:

• 
• 
• 
• 
• 
• 
• 
• 
•