S&P Lawsuit Undermined by SEC Rules That Impede Competition
The U.S. lawsuit against Standard & Poor’s raises pressure to accelerate competition in the ratings industry while the government itself has adopted rules that left the business dominated by the same companies whose flawed grades sparked the worst financial crisis since the Great Depression.
The Justice Department accuses McGraw-Hill Cos. (MHP) and its S&P unit of deliberately understating the risk of bonds backed by mortgages made to the riskiest borrowers to win business from Wall Street banks. S&P, Moody’s Investors Service and Fitch Ratings provided 96 percent of all ratings for governments and companies in the $42 trillion debt market in 2011, versus 97 percent in 2008.
The lawsuit is unlikely to change the relationship because a 2006 law intended to open the field to new entrants has instead insulated the top three. Startups have struggled to obtain the designation that lets them sell rankings because of everything from a missing recommendation letter to prohibitive compliance costs to being able to provide years of ratings performance. Even as the biggest investors say they disregard the grades, their use is still embedded in bond deals and bank reserve rules.
The law “discourages entry and discourages new ideas and new ways of doing things,” Lawrence White a professor of economics at New York University’s Leonard N. Stern School of Business, said in a telephone interview Jan. 24. “Ironically, it reinforces the position of the big three.”
Judith Burns, a spokeswoman in Washington for the Securities and Exchange Commission, which oversees applications for ratings firms, declined to comment on the process.
In 1936, at the depth of the Great Depression, the Office of the Comptroller of the Currency banned banks from holding bonds that were below investment grade, or securities rated under BBB- by S&P and Baa3 at Moody’s. In 1975, SEC regulations designated S&P, Moody’s and Fitch as Nationally Recognized Statistical Rating Organizations, or NRSROs, and required some investors to buy only securities stamped with the companies’ creditworthiness opinions.
Under rules outlined in the 2006 Credit Agency Reform Act, there are now 10 NRSROs.
These changes have helped the seven smaller firms gain market share from the big three in some asset classes. Kroll Bond Rating Agency issued grades on $21.2 billion of commercial mortgage-backed securities last year, the third most behind Moody’s and Fitch, according to Commercial Mortgage Alert, an industry publication. Toronto-based DBRS Ltd. has seen its CMBS rating market share increase 125 percent to $16.5 billion.
Lawmakers targeted the credit-grading business in the 2010 Dodd-Frank Act after the collapse of top-ranked mortgage-backed securities contributed to $2.1 trillion in losses at the world’s largest banks. Reports from the U.S. Senate Permanent Subcommittee on Investigations and the Financial Crisis Inquiry Commission cited failures by the companies as a cause of the financial crisis, which began in August 2007.
According to the complaint filed Feb. 4, S&P falsely represented to investors that its ratings were objective, independent and uninfluenced by any conflicts of interest. The company shaped its analysis to suit its business needs to the extent that one analyst of collateralized debt obligations said loosening the measure of default risk for one security in 2006 “resulted in a loophole in S&P’s rating model big enough to drive a Mack truck through,” the U.S. said.
McGraw-Hill, which agreed to sell its education unit to Apollo Global Management LLC for $2.5 billion in November, fell the most in 25 years after S&P said it expected the lawsuit. Moody’s declined the most since August 2011.
McGraw-Hill and Moody’s, both of New York, each had been trading at five-year highs. McGraw-Hill, which ended last week at $58.34, fell 10.7 percent yesterday to $44.92. Moody’s declined 8.8 percent to $45.09, after a 10.7 percent drop on Feb. 4.
A “competitive moat” around the top three firms has resulted in virtually no change in their market share in the last six years, Peter Appert, an analyst at Piper Jaffray & Co. in San Francisco, wrote in a Jan. 24 report. Investors should buy stock in McGraw-Hill, he said yesterday, because “litigation risk has proven manageable.”
That moat has barely been breached by new SEC rules.
Ann Rutledge, a structured finance specialist, has watched her application to become an NRSRO languish at the SEC for 20 months. Her company, R&R Consulting, has yet to be granted a license because some of the eight client letters don’t meet the requirements of a credit rating as defined by the 2006 law. The statute specifies that only written testimonials that are notarized from institutional buyers attesting to its ratings may be used. R&R’s clients include pension funds, hedge funds and governments.
Rapid Ratings International Inc., a New York-based firm that uses quantitative models to grade securities, hasn’t applied for the NRSRO designation, which would allow investors to buy securities rated by the company to meet regulatory requirements, because its costs would increase by 40 percent to hire compliance staff, James Gellert, chief executive officer, said in a Jan. 7 telephone interview.
“The SEC and Congress say what they want is more competition in the ratings business, yet a lot of people define ratings as being those from an NRSRO,” Gellert said. “We can’t really rate much in structured products without having an NRSRO already, so it boxes firms like us out of that market.”
Meredith Whitney Advisory Group LLC, headed by the former Citigroup Inc. analyst, made a presentation to the SEC in November 2010 seeking NRSRO status and has yet to be approved, according to the SEC website. A woman who answered the phone in the company’s New York office Feb. 4 declined to comment on its application.
Costs have also kept PF2 Securities Evaluations Inc., a New York company that values structured products, from applying for the designation, according to Gene Phillips, a director.
Current regulation “encourages the proliferation of large ratings agencies and discourages smaller and potentially more-focused companies from getting a specific license,” Phillips, a former structured finance analyst at Moody’s, said in a telephone interview Jan. 25.
While the SEC has 90 days to grant a company NRSRO status after receiving its application, the process can take much longer if the document is incomplete or out of compliance, or the company lacks “adequate financial and managerial resources to consistently produce credit ratings with integrity and to materially comply” with requirements, according to the regulator’s website.
Rutledge’s firm, R&R Consulting, evaluates what structured products are worth on a so-called fair value basis, as well as giving the debt a letter grade. The firm was told it could withdraw and reapply for NRSRO status, according to a December e-mail exchange with the SEC.
“Our goal, in tying ratings to price and cash equivalents, statistically and technically, is to move credit ratings into the 21st century,” Rutledge wrote in an e-mail to SEC’s Diane Audino Dec. 7. The SEC has yet to respond. The New York-based company was founded by Rutledge and Sylvain Raynes, who co-authored “Elements of Structured Finance” and “The Analysis of Structured Securities.”
While the SEC can’t dictate ratings methodology, new companies must use the same definitions for credit ratings as the SEC. That restriction is impeding market innovation, according to NYU’s White.
“Letter grades just can’t be the beginning and the end of creditworthiness evaluation,” White, who’s testified before Congress on credit ratings, said. “There’s got to be more ways of doing things than this letter-grade approach.”
Most sophisticated investors no longer use credit ratings to decide which bonds to buy, said Bill Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts. Individual bond-buyers still rely on the grades, he said.
“If you tell them something is AAA today, it’s just like a brand,” Larkin said in a telephone interview. “It’s the only thing they have to go on without digging through balance sheets and looking at company fundamentals.”
Investors repudiated S&P’s decision to cut the top credit grade of the U.S. in August 2011, with a Bank of America Merrill Lynch index returning 9.8 percent that year, the most since 2008.
Even as the SEC has been working to reduce credit rater influence, their grades are still entrenched in financial regulation. The regulator has yet to decide how to remove ratings in the $2.7 trillion market for money funds and in determining what securities broker-dealers may own to meet capital withholding requirements.
Efforts to curb the power of ratings companies are already underway in the European Union. The bloc’s 27 governments are set to rubber stamp measures, approved on Jan. 16, that aim to make it less likely that decisions on sovereign debt roil markets. The proposals will also give investors the right to sue if they lose money because of poor quality or deliberately distorted credit assessments.
The latest global capital rules from the Basel Committee on Banking Supervision still use credit ratings, except in the U.S., where regulators were instructed by the 2010 Dodd-Frank Act not to use them. Regulators say they’ll determine how much capital banks must hold to back bonds by looking at criteria similar to those used by the ratings firms.
Because Dodd-Frank affects regulation only at the federal level, many state and local pension funds still rely on the opinions.
Egan-Jones Ratings Co. was barred from grading government debt and asset-backed securities for 18 months after settling claims it made material misstatements to the SEC last month. The company misled the regulator by asserting it had been ranking the two asset classes since 1995 when registering for NRSRO status, the SEC said in a statement. In fact, the closely held, Haverford, Pennsylvania-based company started rating the debt in 2008, the year it applied for the designation.
Demand for credit ratings reached a record last year as companies sold an unprecedented $3.95 trillion of bonds with the U.S. Federal Reserve holding interest rates between zero and 0.25 percent since 2008.
Moody’s and S&P are able to raise prices because the two are a “natural duopoly,” Warren Buffett, the billionaire chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., told the inquiry commission in 2010. Berkshire is Moody’s largest shareholder, with a 12.8 percent stake.
So far, the rules haven’t dented Moody’s market share.
“The regulation is very onerous,” Mark Adelson, former chief credit officer at S&P and current chief strategy officer for municipal bond insurance startup BondFactor Co., said in a telephone interview. “It sets up a very high barrier to entry and it’s very hard for a fledging rating agency to really get going.”
To contact the reporter on this story: Matt Robinson in New York at Mrobinson55@bloomberg.net
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