Why the SEC’s settlement with credit-rating newcomer Kroll is a big deal

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Kroll Bond Rating Agency came to the bond-rating world with fresh eyes after the 2007-’08 global financial crisis.

On Tuesday, it agreed to pay more than $2 million to the U.S. Securities and Exchange Commission to settle claims that it relied on lax internal controls when assigning its credit ratings to bonds backed by commercial property debt and hybrid corporate debt securities, all in the postcrisis era.

The fine might not seem like a lot, and it’s certainly only a fraction of the billions extracted by the SEC and other financial regulators from big banks and credit-ratings firms in the aftermath of the 2008 crash.

But the securities at the heart of Tuesday’s SEC settlement also come from the same family of exotic assets that played a prominent role in the last decade’s financial crisis, but with the new twist of being put to the test by the deadly global coronavirus pandemic.

Specifically, the SEC claimed that Kroll “permitted analysts to make adjustments” on commercial mortgage-backed securities (CMBS) deals “based on their professional judgment,” while “omitting any” rationale for those changes, when awarding top AAA ratings to bond deals between 2012 and 2017.

Kroll said it “stands behind the integrity of its ratings, methodologies and processes, and neither admits nor denies the findings in the Commission’s Orders,” in a statement to MarketWatch. “KBRA will continue to provide timely and transparent, best in class ratings services and research to the market.”

Why does this matter? Congress passed the Dodd Frank Act of 2010, in part, to better shield investors from the sort of mass defaults and downgrades that shocked markets more than a decade ago, after highly rated mortgage securities failed to live up to their credit ratings when the U.S. housing bubble burst.

At the time, Kroll was just getting its feet wet in bond ratings. Now it also has paid a fine after the SEC said its practices fell short of beefed-up industry standards.

Specifically, the SEC’s order focused on assumptions Kroll analysts made about commercial property cash flows, a topic that’s made headlines in recent months. It’s an important focus because success or failure of property bonds can hinge on how much cash a building brings in relative to its mortgage debt.

But more broadly, the SEC has stepped up its scrutiny of the CMBS market, particularly as waves of property owners of hotels, shopping centers and office buildings have struggled to keep up on their debt payments during the COVID-19 pandemic, according to a person with direct knowledge of the matter.

The person described the Kroll settlement as potentially an opening salvo as the financial regulator investigates CMBS industry practices.

As part of Tuesday’s settlement, the SEC’s Daniel Michael, chief of the enforcement division’s complex financial instruments unit, said, “We will continue to hold credit-rating firms accountable for failing to ensure the integrity of the ratings process.”

Meanwhile, the battered commercial real-estate industry has been calling for more government aid to offset carnage from the pandemic.

See: Commercial real estate ‘somehow has been skipped over,’ for COVID-19 aid. Here’s a plan to change that through equity investments

Property owners were hoping for their buildings to become more fully occupied after Labor Day, but that still seems far off as the nation faces another upsurge in COVID-19 cases, including in New York City.

Seven months into the pandemic, Real Capital Analytics, a commercial property performance and sales platform, estimates that already about $40 billion worth of U.S. property debt is in distress, with the bulk being hotel and retail properties.

For its part, Kroll has gained steady market share in the roughly $550 billion CMBS market, after it first started rating this type of bond deal about a decade ago, putting it alongside industry heavyweights Moody’s Investors Service MCO, S&P Global and Fitch Ratings.

Kroll’s fine also settled claims by the SEC about its ratings on securities tied to pools of corporate debt called “collateralized loan obligations,” a cousin of the now unloved “CDOs” that proliferated a decade ago.

In other market action Tuesday, U.S. stocks also lost a bit more of their luster, with the Dow Jones Industrial Average
S&P 500

and Nasdaq Composite Index

each ending lower and snapping a three-session win streak.

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