Feb. 7 (Bloomberg) -- Fifteen months after Harold “Terry” McGraw III sparked a $4.6 billion stock gain at McGraw-Hill Cos. with a plan to focus the business on its Standard & Poor’s unit, a lawsuit against the credit-ratings firm threatens to cost the company even more.
McGraw-Hill’s market capitalization, which reached a five-year high of $16.2 billion last week, has plunged to $12.1 billion as U.S. prosecutors seek more than five years’ worth of profit as punishment for inflated grades that contributed to the worst financial crisis since the Great Depression. The company’s bonds have declined and the cost to protect the debt against default jumped to a five-month high.
Penalties for false representations, concealed facts and manipulated criteria linked to ratings on portions of more than $4 trillion of debt securities could reach $5 billion, more than enough to exhaust New York-based McGraw-Hill’s $1.2 billion of cash on hand and the $1.86 billion of excess funds that analysts project the company will generate this year. Tapping the bond market to fund any shortfall may cost the company $390 million of interest for every $1 billion borrowed over 10 years.
“You will have at least some intermediate-term value destruction,” said Noel Hebert, chief investment officer at Bethlehem, Pennsylvania-based Concannon Wealth Management LLC, which oversees about $250 million. “It’s likely that they ultimately settle in a way that hurts enterprise value and the creditworthiness, but still keeps them well above water.”
S&P said in a Feb. 5 statement that the Department of Justice’s claims are “meritless” and that “20/20 hindsight is no basis to take legal action against the good-faith opinions of professionals.”
“There was robust internal debate within S&P about how a rapidly deteriorating housing market might affect” securities rated by the company, “and we applied the collective judgment of our committee-based system in good faith,” S&P said.
The lawsuit has left McGraw-Hill with an enterprise value - - or the value of its stock and debt minus cash -- of $13.2 billion, the lowest level since June.
Shares of McGraw-Hill had surged 51 percent through last week since the company bent to pressure from Jana Partners LLC and the Ontario Teachers’ Pension Plan with a proposal on September 2011 to spin off its deteriorating education business. The company agreed to sell the unit to Apollo Global Management LLC for $2.5 billion in November.
The lawsuit has “no impact” on the asset sale, which hasn’t closed, said Jason Feuchtwanger, a spokesman at McGraw-Hill. “We have a fortress balance sheet, limited debt, strong cash position and an excellent cash outlook for the year,” he said.
The company was founded in 1888 by the great-grandfather of Terry McGraw, the current chief executive officer. After McGraw-Hill announced the breakup, he said he was putting aside concerns about abandoning the business’s roots in publishing to serve “shareholders, employees and customers.”
The potential legal penalties, which Acting U.S. Associate Attorney General Tony West said represented a “fairly conservative” estimate of losses suffered by federally insured financial institutions, have reversed the gains in the company’s stock.
McGraw-Hill fell to $43.64 a share at 11:02 a.m., down from $58.34 last week. Its $400 million of 6.55 percent bonds due 2037 dropped almost 7 cents on the dollar to 110.5 cents on Feb. 4 and an equal portion of 5.9 percent debt due November 2017 declined 0.8 cent to 116, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Credit-default swaps linked to the company’s obligations, which pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt, jumped 60 basis points, or 0.6 percentage point, to 150.5 yesterday.
The contracts were quoted as low as 90 basis points last week, according to data provider CMA, which is owned by McGraw-Hill and compiles prices quoted by dealers in the privately negotiated market.
The bond and swap prices imply a credit-rating of Baa2 for the company, according to Moody’s Corp.’s capital markets research group, two steps below the McGraw-Hill’s A3 grade from Moody’s Investors Service. That signals investors may demand a yield of 3.86 percent for new 10-year bonds, according to Bank of America Merrill Lynch index data.
“If a company like McGraw-Hill were to have to pay a $5 billion fine tomorrow, they would potentially need to issue a large amount of debt or issue new equity,” said Alan Shepard, an analyst and money manager at Madison Investment Advisors Inc., which oversees about $16 billion in Madison, Wisconsin.
Borrowing that amount would boost leverage and “imply a downgrade by multiple notches, potentially out of investment grade,” he said.
McGraw-Hill had been in “extensive discussions” with the government over the accusations for at least four months, Floyd Abrams, a lawyer representing the company, said Feb. 5. Settlement talks broke down after the government sought a fine of more than $1 billion and an admission of wrongdoing from S&P, the New York Times reported.
“McGraw-Hill was foolish not to have made a settlement,” Arthur Levitt, a former Securities and Exchange Commission Chairman, said yesterday in a Bloomberg Radio interview with Tom Keene. He estimated any settlement, while probably below the $5 billion the government is seeking, would be “substantial” and that the U.S. would prevail in its lawsuit.
Levitt is a board member of Bloomberg LP and an adviser to Goldman Sachs Group Inc., Carlyle Group LP and Promontory Financial Group LLC.
According to the U.S. complaint, S&P falsely represented to investors that its credit ratings for securities such as residential mortgage-backed securities and collateralized-debt obligations were objective, independent and uninfluenced by any conflicts of interests. Banks create CDOs by bundling bonds or loans into securities of varying risk and return and pay ratings companies for the grades.
S&P rated about $2.8 trillion of RMBS and $1.2 trillion of CDOs from September 2004 to October 2007, the government said.
The accusations are a setback for McGraw-Hill, which is working to boost revenue growth of 2.1 percent in the 12 months through September and increase margins as a content and analytics company in the global capital and commodities markets, according to a November statement.
It also benefits from its status as a Nationally Recognized Statistical Rating Organization because some investors are required to buy only securities stamped with the creditworthiness opinion of an NRSRO.
“In the mortgage area they were slapping AAA ratings on crap,” said Michael Mullaney, chief investment officer at Boston-based Fiduciary Trust Co., which manages $9.5 billion. Mullaney said he cut his reliance on rating companies such as S&P in 2008 as the financial crisis unfolded.
Inflated grades during the credit boom contributed to more than $2.1 trillion in losses at the world’s financial institutions after home-loan defaults soared and residential prices plummeted. The Justice Department complaint is the first federal case against a ratings company for grades related to the financial crisis.
“An admission of wrongdoing or finding of guilt could encourage the government to act more forcefully to reform that business model,” Mark Palmer, an equity analyst for BTIG LLC, a trading firm in New York, said in a telephone interview.
S&P, Moody’s and Fitch Ratings together provided 96 percent of all ratings for governments and companies in the $42 trillion debt market in 2011. There are now 10 NRSROs.
McGraw-Hill’s ratings business accounted for 45 percent of the company’s $1.5 billion in operating income for the 12 months ended Sept. 30, the highest portion of any unit, Bloomberg data show. Net income of $867 million in that period will rise to $1.07 billion this year, according to analyst estimates compiled by Bloomberg.
While McGraw-Hill would have the capacity to raise $5 billion through a combination of debt and equity and still survive as a high-yield company, the potential stain to its reputation is a bigger risk than any fine, according to Joel Levington, managing director of corporate credit for Brookfield Investment Management Inc. in New York.
“You can overcome debt leverage and pay it down, but if your brand, which is based on integrity, is tainted, I don’t know how you get around that,” Levington said in a telephone interview.
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