Credit Ratings, Procyclicality and Related Financial Stability Issues: Select Observations

On April 24, the SEC announced the formation of an internal, interdisciplinary COVID-19 Market Monitoring Group.[1]  This temporary, senior-level group was formed to assist the Commission and its various divisions and offices in (1) developing Commission and staff analyses and actions related to the effects of COVID-19 on markets, issuers and investors—including in particular our long-term Main Street investors, and (2) responding to requests for information, analyses and assistance from fellow regulators and other public sector partners on market matters arising from the effects of COVID-19. 

One of the COVID-19 Market Monitoring Group’s initial initiatives[2] has been the exploration of whether credit assessments and credit rating agency downgrades—and market anticipation of, and responses to, those ratings actions—may (1) contribute to negative procyclicality in certain circumstances and (2) have implications for financial stability.  The interrelationships between ratings actions, procyclicality and financial stability is a topic that other members of the global financial regulatory community are also examining,[3] and we have benefitted from our ongoing coordination and sharing of analysis and observations with them.

While our work on this topic—and more broadly, other issues relating to COVID-19’s effects on markets, issuers and investors—is ongoing, we have several initial observations concerning ratings actions, procyclicality and financial stability issues that we believe would be helpful to share with the public.  Specifically, and as discussed in more detail further below, our initial observations are: 

1. Analysis of potential effects of ratings actions should focus on current circumstances.  Given the idiosyncratic nature of the health and economic effects and consequences of COVID-19, we believe that analogies to the role of rating agencies in the 2008 global financial crisis should be approached with caution.  We note that, in addition to substantially differing economic conditions and stresses, the relevant analytical assumptions and methodologies used by rating agencies in that period also were substantially different. 
2. Cost of debt capital is driven by a wide range of financial and non-financial factors and forces; ratings downgrades are generally lagging indicators of cost of debt capital. 
3. Observable bunching just above and below the investment grade level may be attributable to various macroeconomic trends, including policy, regulatory and investor choices. 
4. When considering the effects of credit ratings on market structure, including potential procyclicality of ratings downgrades, it is important to take into account the wide and diverse spectrum of our credit markets and all major credit market participant types. 
5. The procyclical effects of credit ratings used in bilateral specialty finance also are appropriate areas for continued monitoring. 

We welcome information, data and comments from market participants and members of the general public—both on this specific topic and other matters and issues relating to COVID-19’s effects on our capital markets.  Submissions can be made by email to COVID-19.Market.Monitoring.Group@sec.gov.

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1. Analysis of potential effects of ratings actions should focus on current circumstances.  Given the idiosyncratic nature of the health and economic effects and consequences of COVID-19, we believe that analogies to the role of rating agencies in the 2008 global financial crisis should be approached with caution.  We note that, in addition to substantially differing economic conditions and stresses, the relevant analytical assumptions and methodologies used by rating agencies in that period also were substantially different. 

In response to the broad and varied effects and unparalleled response to COVID-19, rating agencies have made, and continue to make, adjustments to the analytical assumptions and other inputs that they use when assigning and maintaining ratings.  This includes, for example, adjusting the baseline macroeconomic scenarios and sector outlooks that their models and analysts apply, as well as modifying other key qualitative and quantitative assumptions used in their methodologies.  Also, speaking more generally, rating agency models and methodologies—as well as the marketplace’s use of ratings—have evolved significantly in the years following the 2008 global financial crisis.

In light of these differing factors and changes, as well as the significant post-financial crisis changes to the marketplace itself and the regulatory scheme governing ratings and financial services generally, we believe that analogies to the 2008 global financial crisis era—including the analytical assumptions and methodologies rating agencies used in that period—should be approached with caution and, in themselves, are not likely to provide useful decision-oriented analyses or insights.  In our view, it is a more effective use of regulatory resources to focus, in the first instance, on (1) identifying and understanding the policies, procedures, methodologies and practices of rating agencies today (including the economic forecasts and assumptions applied) and (2) the ways in which all significant classes of investors and other market participants use ratings in their asset allocation, credit provision and other decisions. 

When exploring the role of credit ratings in today’s market structure, including potential regulatory actions, it is important to understand a key aspect of the U.S. legal and regulatory construct.  Congress explicitly prohibited the SEC and the states from regulating the substance of credit ratings or the procedures and methodologies by which they are determined.[4]  The statute and rules applicable to SEC-registered rating agencies require rating agencies to establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures and methodologies for determining credit ratings, and provide the SEC staff with authority to examine rating agencies’ compliance with such provisions.  Operating within this framework, the SEC staff has focused its recent efforts in this area on, among other things:  (1) understanding how rating agencies are responding to the economic effects of COVID-19, including monitoring ratings actions and related public disclosures to understand the overall market impact of the actions, and (2) examining rating agencies’ adherence to their own policies, procedures and methodologies for determining credit ratings.

2. Cost of debt capital is driven by a wide range of financial and non-financial factors and forces; ratings downgrades are generally lagging indicators of cost of debt capital. 

We have observed in discussions with other regulators, that there are perceptions that the procyclical effects of increases in the cost of debt capital are the result of ratings downgrades.  This is unlikely to be a strong or dominant causal relationship in, for example, the bank lending or the new issue bond market.  A firm or issuer’s cost of debt capital—be it through bank/non-bank financing and/or debt capital markets—is driven by a wide array of geopolitical, economic and credit conditions and other industry- and firm-specific factors.  Rating agency actions—including (1) changes in rating outlook, (2) placement on or changes in “watch” status and (3) changes in ratings—are generally lagging indicators of cost of debt capital. 

Generally speaking, before a rating downgrade occurs, market participants observe—and take into account by commanding (generally) higher credit spreads —the relevant conditions and circumstances that eventually contribute to the ratings action—e.g., (1) broad conditions and factors, such as the state of the business climate and credit markets, the regulatory environment, and the competitive landscape affecting the firm or its industry, and (2) firm-specific information and circumstances, such as the demand for the firm’s goods and services, as well as the entity’s growth prospects, asset quality, funding and profitability, and management approach—some of which is commonly available in public financial statements and regulatory filings.

Indeed, most of the credit spread widening for downgraded issuers occurs before the downgrade.[5]   As the Coronavirus spread globally in early 2020, the cost of debt capital for many companies shot up, as the marketplace observed the virus’ effects on economic activity—before the rating agencies began to drop companies’ ratings.

We do, however, recognize that in certain circumstances an adverse ratings action may have some negative effects on the cost of debt capital.  For example, in the case of collateral-based financing such as a receivables facility, if the ratings of the borrower or the entities that owe the borrower the receivables is downgraded, additional collateral may be required which would increase the borrower’s cost of capital.  In addition, while we would expect the market to anticipate the ratings action and adjust accordingly, a move from investment grade to below investment grade could have significant effect on cost of debt capital (see below for further discussion of issues related to the potential investment grade / below investment grade discontinuity in the market).  

3. Observable bunching just above and below the investment grade level may be attributable to various macroeconomic trends, including policy, regulatory and investor choices. 

There has been observable segmentation of the credit investment universe for certain types of investors, including between investment grade and non-investment grade credits.  There also has been observable concentration of credit in the area around the line between investment grade credit and below investment grade credit.  It is important to note that this segmentation and concentration (as well as, in some cases, a relatively significant credit spread differential between low investment grade and high non-investment grade credits) is attributable, in large part, to various fundamental business differences, investor demand, macroeconomic factors and monetary and regulatory policies. 

The factors that have driven this segmentation and concentration of credit in the area around the line between investment grade credit and below investment grade credit include, among others:  (1) a market-wide recognition (and incorporation into investment strategies) of the significant differences in historical default rates[6] between the highest non-investment grade and lowest investment grade ratings, (2) long-running accommodative monetary policy, which caused investors to seek increased yield within their mandates and, in turn, provided corporates with the opportunity to increase their debt financing at low absolute rates, (3) investor demand focused on the highest yielding investment grade credits, (4) regulatory capital requirements on banks, insurance companies and other entities that pushed lower investment grade and below investment grade credits off regulated balance sheets and (5) investment guidelines and index investing that themselves incorporate segregation.  Over the period following the 2008 global financial crisis, these policy positions and regulatory actions, coupled with relatively stable investor preferences, facilitated easier and predictable credit conditions, which incentivized borrowers in various segments to optimize their balance sheets to achieve ratings in the low investment grade range.[7]  This type of balance sheet optimization may have significantly contributed to the current concentration of credit in and immediately above (as well as immediately below) the BBB-/Baa3 categories.  In other words, examining ratings and ratings actions in isolation from these other factors is unlikely to provide meaningful insight.

4. When considering the effects of credit ratings on market structure, including potential procyclicality of ratings downgrades, it is important to take into account the wide and diverse spectrum of our credit markets and all major credit market participant types. 

Certain portions of our credit markets, including fixed income mutual funds and ETFs, leveraged loans and CLOs, have grown significantly in recent years and attracted increased regulatory attention.[8]  We believe that these aspects of the credit markets are worthy of continued monitoring and examination, including in particular whether they will continue to grow in absolute and relative terms.  Other issues that warrant monitoring in these portions of the market include where leveraged loans and CLOs are held (i.e., who are the principal investors), the purposes for which they are being held (e.g., long term or short term investing) and their relative credit and liquidity risk tolerances (e.g., how willing or able are they to withstand periods of price dislocation and/or limited liquidity).  At the SEC, we are monitoring these areas, and are engaging in related inter-agency discussions to gain a better understanding of these evolving issues.

However, when considering credit markets generally, and the extent and effects of reliance on ratings within areas of our credit and financial markets, including procyclicality of ratings downgrades, we believe that the broad spectrum of credit markets and institutional investor types active in these markets must be considered—including insurance companies and pensions, among others.  For example, registered investment companies (a category that includes money market funds and other mutual funds, as well as ETFs) account for approximately:  21% of the U.S. and foreign corporate bonds market, 14% of the U.S. and government agency securities market, 29% of the U.S. municipal securities market and 25% of the commercial paper market.[9]  Other types of institutional investors, therefore, both individually and collectively, play a significant role in these markets.  It is only with a wide lens—that looks across all significant market participant types—that we can collectively identify, monitor and evaluate the key trends, developments and risks across these markets, including potential procyclical effects of credit ratings.  We recognize that data availability for these other significant market participants may be more limited but data availability should not drive the focus of our analysis.

5. The procyclical effects of credit ratings used in bilateral specialty finance also are appropriate areas for continued monitoring. 

Many members of the global financial regulatory community have focused on the procyclicality of investment guidelines, performance benchmarks and other rating-oriented portfolio construction rules.[10] 

While these areas deserve ongoing attention, we also believe that the potential procyclical effects of credit ratings used in bilateral specialty finance also are worthy of continued monitoring.  Fundamentally, these types of financing arrangements are asset-backed and secured. 

While industry has made significant strides to reduce the use of credit ratings especially in broadly distributed asset-backed financing deals,[11] some types of bilateral financing, short term funding and supply chain financing arrangements continue to rely in various ways on credit ratings, at times directly, but in most cases indirectly.  For example, in receivables financing arrangements, or other similar arrangements where the reference collateral pool or borrowing base itself has ratings, there are usually contractual provisions to post additional or substitute collateral if posted collateral no longer maintains a specified rating, so as to maintain the borrowing base and the advance rate.  In other cases, there is an indirect, but tangible impact of a downgrade of the corporate entity related to the bilateral asset-backed financing agreement as result of (1) servicing obligations of the entity, (2) serving as a counterparty to the financing trust (such as a swap counterparty), or (3) general confidence of the financing provider on the ability of the entity to access the non-secured financing markets.  In addition, market participants, especially in bilateral settings, usually impose credit rating style financial criteria, which while not mechanistically linked to ratings, are likely to mimic ratings outcomes.

In all of these examples, ratings downgrade or other credit events could result in increased financing costs or reduced access or liquidity pressures on the corporate entity.[12]  These and similar types of scenarios could contribute to negative procyclicality and market disruptions.  We believe these matters are worthy of continued examination.