(Bloomberg) -- Collateralized loan obligations offer investors higher yields and credit grades than other asset classes thanks to large doses of Wall Street alchemy.

But that safety may be fleeting, according to a new study, which says that the widespread failure of rating companies in recent months to downgrade CLOs in line with their underlying loans has made them significantly riskier than they appear.

The authors concluded that conflicts of interest are likely the primary force pushing firms including S&P Global Ratings and Moody’s Investors Service to avoid downgrading CLOs for now. Collateral managers may also be taking advantage of rating company methodologies to make CLOs seem safer than they really are, according to the study.

Spokespeople for Moody’s and S&P said they stand by their ratings and their methodology.

The findings, from researchers at the Massachusetts Institute of Technology and the University of Texas, suggest that one of the root causes of the 2008 crisis is becoming a problem in the market for securitized debt once again. Over a decade ago, overly rosy assessments on mortgage-backed securities by credit graders contributed to a collapse in the U.S. housing market and helped nearly bring down the global financial system.

“Inaccurate credit ratings have the potential to harm investors, misallocate capital, and create systemic risk,” MIT’s Jordan Nickerson and Texas’s John Griffin wrote in the study.

Rating firms downgraded about 25% of leveraged-loan collateral bought by managers since the pandemic started through August, according to the report. In contrast, they’ve only downgraded about 2% of the CLO bonds themselves. There were about $700 billion of CLOs outstanding as of mid-September.

The study suggests that raters are including subjective and undisclosed factors in assigning risk. It also notes that collateral managers may be using “window-dressing” loans to boost the grades of their portfolios.

Griffin is an owner of Integra FEC LLC, a fraud-consulting firm, and both he and Nickerson consult on credit ratings issues for the firm.

A Disconnect

The pandemic led to an unprecedented wave of corporate loan downgrades as companies struggle to pay their debts. Beginning in March, S&P and Moody’s began cutting large swaths of leveraged loans, which CLOs package and sell into chunks of varying risk and return. Many of the loans were already on the cusp of CCC prior to the pandemic. The downgrades stabilized by mid-June.

The new ratings filtered into CLOs, causing many to exceed their limits for soured, lower-rated debt and tripping safeguards built in to protect investors. Rating companies began reducing their credit grades, but not to the same extent as the underlying loans.

“The CLO downgrades are far and away concentrated so far in the more subordinate tranches, yet the agencies’ own disclosures, in some instances, had predicted more senior tranches would be downgraded if the portfolio deteriorated to a certain level,” Nickerson said.

The authors say Moody’s own disclosures initially showed that more bonds in the Aaa to Baa range would likely get downgraded as many as two notches if a measure of a portfolio’s credit risk rises by 15%. That metric rose near that level, yet mostly subordinate single-B and double-B tranches were downgraded, while higher-rated bonds were left untouched.

In fact, Moody’s should have downgraded more than 9% of the Aaa CLO tranches it rates by August, based on its own published criteria, the study said. Yet none were cut.

A Moody’s representative said CLO tranches that carry a Aaa rating benefit from strong structural protections and continue to perform well despite the pandemic.

“We review our ratings on an ongoing basis and take action where appropriate to reflect our forward-looking views of credit risk,” said spokeswoman Bronwyn Collie.

For S&P, the authors found that 8% of AAA tranches do not meet the rater’s primary modeling criteria for CLOs because they would not be able to withstand the number of defaults projected in a “worst-case scenario.” Yet S&P has not downgraded nor placed any AAA tranches on credit watch.

In response, the company said that analysts may make qualitative adjustments when rating CLO tranches due to Covid-19’s potential near-term affect on the credit quality of underlying CLO assets. It said that transparency and consistency with its published methodologies are top priorities when assigning ratings.

“Credit ratings are typically not point-in-time assessments, but rather forward-looking evaluations that are subject to -- and require -- surveillance over time in order to reflect changes in creditworthiness,” S&P spokesman Luke Shane said via e-mail. “Our ratings are based on quantitative and qualitative analyses of available information by experienced professionals.”

‘Gaming The System’

CLOs are actively traded portfolios, and since rating companies assess the collateral pool at a point in time, managers might be choosing “window-dressing” loans to shore up their portfolios. Managers began trading into shorter-duration loans as the Covid-19 crisis started in order to be treated more leniently by rating models, potentially “gaming the system,” the report said.

However, structures that have strong features and talented collateral managers are typically able to navigate the heightened risk, said Jason Merrill, an investment specialist at Penn Mutual Asset Management.

“It is a combination of a misunderstanding of the strength of the CLO structure, and a lack of confidence in rating agencies’ ability to model future stresses, that would lead one to expect tranches to experience further downgrades at this point,” Merrill said.

CLO managers have sought out increased trading flexibility this year in order to shore up deteriorating portfolios. While managers have always pursued loopholes to improve outcomes, some debt investors who have fought them in the past are this year in favor of allowing flexibility with their loan trading to improve performance.

However, the authors maintain that managers may be strategically picking loans with shorter lives in order to superficially make the CLOs appear less risky.

“Through the lens of rating agency methodologies, this action reduced the model-implied default probability of the underlying collateral,” according to the report, which analyzed nearly $600 billion of CLOs issued between 2014 and 2019 that were impacted this year by leveraged loan downgrades. “While we cannot rule out other possible reasons for a change in managerial behavior, this result is consistent with a change in collateral manager actions to exploit particular features of credit rating agency models.”

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