MIT Sloan study finds significant disconnect between credit agency ratings and CLO risk

CAMBRIDGE, Mass., Oct. 8, 2020 /PRNewswire/ -- During the COVID-19 crisis, S&P and Moody's downgraded approximately 25% of the collateral feeding into collateralized loan obligations (CLOs), yet the value of CLO tranche downgrades was approximately 2%. A recent study by MIT Sloan School of Management Visiting Prof. Jordan Nickerson suggests two explanations for this disconnect: Ratings agencies could be using subjective factors to assign risk; or portfolio managers could be strategically using "window-dressing" to make CLOs appear less risky.

"Ratings agencies were slow to downgrade structured finance products and CLOs in the financial crisis of 2007-2008, and it looks like we may be repeating history during the current COVID-19 crisis. There is a significant mismatch in the response of ratings agencies and the current economy," says Nickerson, noting that his study includes credit watches.

He adds, "If the credit ratings are wrong, investors will not only lose trust in the ratings agencies, they also could lose a lot of money."

In a study conducted with Prof. John M. Griffin of the University of Texas-Austin, Nickerson identified two possible explanations for the disconnect in ratings.

First, the ratings agencies could be slow to act because they are basing decisions on subjective factors. "When our tools and models cannot explain their ratings, one of the leading explanations left to consider is that they are using qualitative factors. If subjectivity is impacting the ratings, then we should be concerned about conflict of interest," explains Nickerson.

He points out that conflict of interest was also a concern during the financial crisis of 2007-2008, when disconnected ratings led to government investigations. The current disconnect of ratings and risk could trigger similar investigations.

Second, portfolio managers could be strategically picking loans that appear less risky from the perspective of a ratings agency. For example, says Nickerson, loans that are due in two years versus four years may be deemed safer. So, managers may purchase loans with shorter maturities versus longer maturities.

"The risk hasn't changed, but the pool of loans is window-dressed to appear safer. Managers could be strategically picking loans that superficially look less risky," he says. "If this is the case, ratings agencies should reconsider how they rate loans, so they aren't susceptible to window-dressing."

He notes, "In either case, ratings agencies need to respond to this disconnect and decide whether to update their approaches. In the meanwhile, investors should start to do more due diligence and look beyond the ratings before they invest. And policymakers should take notice, especially because it impacts many investors through structured investments and pension plans."

The MIT Sloan School of Management is where smart, independent leaders come together to solve problems, create new organizations, and improve the world. Learn more at mitsloan.mit.edu.

SOURCE MIT Sloan School of Management