S&P Selective Disclosure Prompts Scrutiny of Who Learned Ratings Too Early
As Standard & Poor’s considered the first ratings downgrade of the world’s biggest economy in late July, some of the largest bond investors held undisclosed meetings with the firm that would ultimately strip the U.S. of its AAA grade.
BlackRock Inc. (BLK), Western Asset Management, and TCW Group Inc., which oversee almost $4 trillion, were visited by S&P, after the company had said publicly that there was more than a 50 percent chance of a cut, said people familiar with the conversations who declined to be identified because they were private. Ed Sweeney, a spokesman for S&P, says such talks are an attempt to make the ratings process more transparent.
While these meetings can be legal, they underscore the influence granted to the ratings companies during the Great Depression to say what’s safe and what’s risky in the $35 trillion U.S. fixed income market. The sessions provided some investors more access than others at a time when confidence in the global financial system has yet to recover from the subprime crisis that the firms helped create.
“This isn’t an ordinary commercial enterprise we’re talking about,” said Robert Hillman, a professor at the University of California, Davis, School of Law and the institution’s fair business practices and investor advocacy chair. “We want to expect more of a company like S&P.”
S&P, Moody’s Investors Service, and Fitch Ratings are the largest of 10 firms approved by the U.S. Securities and Exchange Commission to assign credit rankings used by investors and regulators to evaluate securities. Many pension and mutual funds require minimum ratings to buy debt, and banks generally must hold more capital to back bonds deemed of lower quality.
Laws that forbid companies from privately disclosing material information generally don’t extend to conversations between corporations and ratings companies, which are designated by the SEC as Nationally Recognized Statistical Rating Organizations, or NRSROs. They must create and follow internal policies governing disclosure and obey insider trading statutes.
S&P placed its AAA rating for the U.S. under review for downgrade on July 14, saying the move signaled “at least a one- in-two likelihood” of a cut within 90 days.
Fitch and Moody’s reviewed the government at the same time and affirmed their top grades. S&P’s downgrade, on Aug. 5, even after the Treasury claimed the firm made a $2 trillion calculation error, contributed to stock losses that left shareholders $1 trillion poorer by Aug. 25. Treasury investors have repudiated the assessment, pushing 10-year notes to a record low yield of 1.85 percent yesterday.
BlackRock, the world’s largest money manager, with more than $3 trillion in assets, Western Asset, which oversees about $365 billion, and TCW, which handles $115 billion, met with S&P officials after the company placed the U.S. under review, according to the people familiar with the matter. The investors and S&P declined to comment on what was discussed.
Some of the meetings preceded by at least a week the Aug. 2 agreement by President Barack Obama to cut $2.4 trillion of spending to gain approval from lawmakers to raise the nation’s deficit ceiling and avert a default, the people said. S&P had indicated publicly that anything less than $4 trillion would jeopardize the rating.
Talks between the ratings firms and investors can be acceptable because the graders usually provide public disclosures explaining the evolution of their views about an issuer’s creditworthiness, Douglas Arthur, a New York-based analyst at Evercore Partners Inc., said in a telephone interview.
“They typically move slowly and gradually and send signals to the market in terms of the direction they’re going, so there are not a lot of surprises,” Arthur said. “Also, having conversations with the movers and shakers is part of their information discovery.”
The talks are “part of the regular outreach that we have,” said John B. Chambers, chairman of S&P’s sovereign debt rating committee, at the Bloomberg Markets 50 Summit in New York Sept. 15. “One of the issues we talked with investors about was whether they thought there would be forced selling after such an announcement, and would have done that whether it was the U.S. or anybody else that had so much market debt.”
While all the rating groups say their policies prohibit analysts from disclosing non-public information, investors often try to use the conversations to gain an edge in predicting upgrades and downgrades, according to former employees.
Harvey Pitt, the chairman of the SEC from 2001 to 2003, said in an e-mail that private talks with investors represent “a double-edged sword,” sharpened by legislation enacted by Congress last year.
Even though thorough information-gathering improves rating firms’ analysis and is mandatory under proposed new rules in the Dodd-Frank Act, “the mere fact that one is required to do due diligence doesn’t mean that one has a license to reveal the direction in which a proposed rating is likely to head,” said Pitt, now head of Washington-based consulting firm Kalorama Partners LLC.
Given the market’s hunger for exclusive information, “it’s kind of a difficult balancing act,” said Jerome Fons, executive vice president at Kroll Bond Ratings Inc. and former managing director in Moody’s credit policy and financial institution groups.
“One might assume what the buy-side is the most interested in is information about potential ratings moves,” Fons said. “So they may be looking for body language.”
S&P said it increased contacts with bond buyers since the financial crisis that began in 2007 and led to more than $2 trillion in writedowns and losses at the world’s largest financial institutions, according to data compiled by Bloomberg.
In reports this year, the independent Financial Crisis Inquiry Commission and a Senate investigative panel concluded the firms lowered standards to win business from issuers who pay for credit grades and cut inflated rankings too slowly.
“Over the last several years, S&P has taken many steps to make the ratings process more transparent, including increasing our interaction with investors, policy makers, and the press,” Sweeney, the S&P spokesman, said in an e-mail. “We speak with thousands of investors annually and S&P is committed to reaching as many market participants as possible with its views on credit risk.”
Analysts limit their comments on rating-related matters to previously published material, Sweeney said in response to questions about the conversations ahead of the U.S. downgrade, which were reported by the Wall Street Journal on Sept. 7.
Moody’s policies say workers can’t “give any guidance of possible future rating actions, except to the relevant issuer or its designated agents” and can’t share the information internal except on a “need-to-know” basis, according to a copy provided by Michael Adler, a spokesman. Employees are expected to follow the policies, he said.
“We regularly meet with investors and other market participants to discuss published ratings and commentary, but Fitch policy clearly limits such discussions to our previously published material,” Daniel Noonan, a Fitch spokesman, said in an e-mail.
After the U.S. downgrade, bond yields fell to record lows. Warren Buffett, the world’s most successful investor, said the U.S. should be rated “quadruple A” rather than AA+. S&P, a unit of New York-based McGraw Hill Co., said last month it would replace President Deven Sharma with Douglas Peterson at year- end.
Some investors said access to the ratings analysts may depend on how much money they manage or the fees paid to the firm for services.
Fees for Access
In addition to payments from issuers, rating firms may charge investors as much as hundreds of thousands of dollars for access to research that goes beyond public news releases as well as the opportunity to have conversations with analysts, said Kroll’s Fons. Kroll Ratings, the company founded by Jules Kroll that began grading debt this year, doesn’t now charge investors.
Bonnie Baha, the head of global developed credit in Los Angeles at DoubleLine Capital LP, which manages $16 billion, said her company wasn’t visited by S&P about the U.S. credit rating before the downgrade, nor did she request a meeting.
“I guess size matters,” Baha said. “They wanted to go to centers of influence who are also their biggest customers.”
Thornburg Investment Management Inc., which oversees about $83 billion, questioned if size gave their rivals an advantage.
“It strikes me as odd that they would release, or even just intimate, that information to a select group of folks,” said Jason Brady, a managing director for Thornburg in Santa Fe, New Mexico. “I don’t really agree with that and I am a paying S&P subscriber.”
The SEC’s Regulation FD, which stands for fair disclosure and bars corporate officers from revealing market-moving information to favored investors before general dissemination, doesn’t apply to conversations between rating firms and investors because the analysts aren’t providing information about their own companies, said John Coffee, a law professor at Columbia University in New York.
Laws barring insider trading could apply, he said. The firms could also be censured or lose their NRSRO status for employee violations of their own policies, Coffee said.
Hedge Funds Subpoenaed
The SEC sent subpoenas to hedge funds as part of an investigation into whether some investors traded on confidential tips ahead of S&P’s decision, a person briefed on the matter said Sept. 20. The probe will likely focus on firms that made unusually large bets that markets would decline, ahead of the announcement, according to the person, who spoke on condition of anonymity because the investigation isn’t public. The subpoenas were reported by the Wall Street Journal on Sept. 20.
Rating firms are trying to rebuild their reputations after being blamed for fueling the U.S. housing bubble with AAA grades on mortgage debt that helped push the nation into the biggest recession since the 1930s.
When the values of top-rated mortgage securities plummeted, losses spread across the world, leading to the collapse of Lehman Brothers Holdings Inc. three years ago, a seizure in credit markets and the longest recession since the 1930s.
Investors are set to ultimately lose $378 billion, or 73 percent, on the $517 billion of collateralized debt obligations used to repackage mortgage bonds from 2005 through 2007, according to a paper released last month by researchers at the Federal Reserve Bank of Philadelphia. After being hired by banks to rate the securities, S&P, Moody’s or Fitch gave top grades to more than 75 percent.
Seeking an Edge
Graciana del Castillo, a former S&P analyst who helped oversee its upgrade of Mexico to investment grade in 2002, said investors often seek an edge in predicting ratings when talking with analysts. At the same time, the conversations can provide value to the analyst, she said.
“When you decide on a rating, it’s very important to have as much information as you can, and for that you have to be constantly talking to people,” said del Castillo, who is now a director in New York at consulting firm Macroeconomic Advisory Group and adjunct professor at Columbia University’s School of International and Public Affairs.
It’s inappropriate for the firms to use conversations with investors to gauge the impact of their decisions, said Joel Levington, a former S&P rater who is now managing director of corporate credit at Brookfield Investment Management, which oversees $24 billion of fixed-income assets. Ratings analysts need to have the courage of their convictions and not be swayed by potential market reactions to their decisions, he said.
“That’s really not the role of a rating agency,” he said. “The rating agency is there to make an independent call on what they think credit quality is, period.”
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