Man Who Knew Too Much on Ratings Says They Aren’t Meaningful
Ratings companies, whose scores have helped determine the cost of money for governments and businesses for more than a century, are no longer trusted by the world’s biggest investors, according to the former head of structured finance at Standard & Poor’s.
“They’re there because people have to have them, not because people believe in them,” David Jacob, who was fired from S&P in December, said in an interview at Bloomberg headquarters in New York. “Maybe retail investors do, that’s the unfortunate part, but I think institutional investors don’t.”
After helping ignite the worst financial crisis since the Great Depression by inflating grades on securities backed by subprime mortgages, the ratings firms’ reputations are being diminished further in the bond market. When S&P downgraded the U.S. government in August, Treasury yields fell to record lows, and the cost of protecting financial debt declined following last month’s downgrades of 15 global investment banks by Moody’s Investors Service.
Jacob, hired four years ago to help restore confidence in S&P, says policy makers haven’t gone far enough to reduce reliance on the ratings companies, granted the authority by U.S. regulators 76 years ago to determine which borrowers deserve credit.
The ratings business is now dominated by S&P, a New York- based unit of McGraw-Hill Cos., Moody’s and Fitch Ratings. The three produce a combined $4 billion in annual revenue with 3,600 analysts ranking 2.73 million securities worldwide in the $43 trillion global bond market.
“Ratings are not God’s holy work,” said Jacob, 56, a graduate of Queens College in New York with degrees in math and finance from New York University. “It’s a business. It’s a fine balance between trying to get a certain amount of market share versus losing your credibility.”
Bond investors respond faster than ratings firms to shifts in risk, Ken Fisher, chief executive officer and founder of Woodside, California-based Fisher Investments, said in a telephone interview after Moody’s downgraded Morgan Stanley (MS), UBS AG (UBSN) and 13 other global banks on June 21.
“Moody’s is not going to detect some problem in advance and move a rating to warn the public,” said Fisher, whose firm manages about $44 billion. “Whether it’s a stock or a bond, the free market already did that. Moody’s goes along afterwards and effectively validates what the market’s already done.”
Spokesmen for S&P, Moody’s and Fitch declined to respond to Jacob’s remarks.
S&P President Douglas Peterson said at a meeting of the Institute of International Finance in Copenhagen on June 6 that ratings companies help ensure that bond issuers provide “transparent information” under “strict standards of governance and control.”
During the housing boom, analysts at the three firms were pressured to give their stamp of approval to complex investments to win lucrative business from Wall Street banks, the Senate Permanent Subcommittee on Investigations said last year in a report.
With the cooperation of the ratings companies, bankers spun risky mortgages into securities supposedly as safe as government bonds, allowing risky lending to accelerate.
In 2007, the year before Jacob took over, S&P’s structured finance group took in $561 million in revenue, sometimes charging banks more than $1 million to rate a single offering, according to the Senate panel. About 90 percent of AAA securities backed by subprime mortgages from 2006 and 2007 were later cut to junk, or below Baa3 by Moody’s and lower than BBB- at S&P.
The credit crisis that followed still weighs on economic growth worldwide. Home prices in the U.S. are off 34 percent from their peak in July 2006, according to the S&P/Case-Shiller index. Governments were forced to bail out banks that faced $1.5 trillion in writedowns and losses.
Jacob joined S&P after managing commercial- and residential-mortgage bond groups at Nomura Holdings Inc. from 1993 to 2007. He said he sought to ensure that S&P analysts didn’t loosen standards at the request of bankers. The firm won less business in certain areas as a result.
“We’ve swung back from where it was before when it felt more like the Wild West, but of course it puts a crimp on the business,” Jacob said in the interview last month. “It’s important for investors to watch to see if there’s a change and a shift in terms of trying to rebuild that market share.”
Peterson has been bringing in new executives after a series of miscues at S&P, including a bungled commercial-mortgage deal and its handling of the U.S. downgrade, said Appert, who doesn’t know Jacob or his particular circumstances.
Peterson demoted Mark Adelson from chief credit officer to a research role last year, and Barbara Duka, head of commercial- mortgage ratings, was replaced.
“Peterson was brought in to try to address some of these issues and tighten up operations,” said Appert, who has the equivalent of “buy” ratings on McGraw-Hill and Moody’s stock. McGraw-Hill fell 0.2 percent to $44.70 today.
S&P cut the credit grade of the U.S. one step to AA+ in August, criticizing lawmakers for failing to cut spending or raise revenue enough to reduce record budget deficits. After the Treasury Department said S&P made a $2 trillion error in its calculations, the ratings company switched the budget projections it was using and proceeded with the downgrade. S&P denied it made a mistake and said using the government’s preferred fiscal scenario didn’t affect the credit rating.
Following the downgrade, yields on 10-year Treasuries fell to as low as 1.45 percent in June from almost 3 percent last August, indicating investors view the U.S. as more creditworthy, not less. Almost half the time, yields on government bonds fall when a rating action by S&P and Moody’s suggests they should climb, according to data compiled by Bloomberg on 314 upgrades, downgrades and outlook changes going back as far as the 1970s.
Grading government bonds is outside ratings companies’ traditional areas of expertise, Jacob said.
“You’re talking about politicians, you’re talking about legislators, you’re not talking about credit risk,” he said. “I don’t see how a rating agency has any better call on it than you or me or anybody else.”
Moody’s, which helped start the business of ranking companies by their ability to repay debt in 1909, cited “the volatility and risk of outsized losses inherent to capital- markets activities” for its bank downgrades, according to a June 21 statement.
While Moody’s now has the banks rated an average four levels lower than at the height of the financial crisis, investors see the lenders as more creditworthy. Yields on their bonds fell to an average 3.77 percent as of yesterday from 8.46 percent in October 2008, Bank of America Merrill Lynch index data show.
The cost of protecting the banks’ debt from default fell as much as 26 basis points after the downgrades, Bloomberg data show. As of yesterday, the average was down 1 basis point to 245, meaning it costs $245,000 a year to insure against losses on $10 million of their bonds.
In response to the ratings companies’ role in the credit seizure, the U.S. passed the Dodd-Frank overhaul of financial regulation in 2010, instructing regulators to remove references to ratings in the rules that determine everything from bank capital to money-market fund holdings.
In Europe, lawmakers are debating new rules that would force banks to rotate which companies they hire to grade certain securities and restrict when sovereign ratings could be released.
The ratings companies’ grades have carried extra weight since the Office of the Comptroller of the Currency banned banks from holding bonds that were below investment grade in 1936.
“We have a longstanding integration of ratings into financial regulation,” Larry White, a professor at New York University’s Stern School of Business who’s testified before Congress about credit ratings, said in a telephone interview. “That has unnecessarily enhanced the importance of the big three rating firms.”
Moody’s and S&P have become a “natural duopoly,” able to sell their services even to those who don’t like them, Warren Buffett, the chairman of Berkshire Hathaway Inc., told the Financial Crisis Inquiry Commission in 2010. Berkshire is an “unwilling customer” of Moody’s when it issues bonds, Buffett said.
That hasn’t stopped the world’s third-wealthiest man from appreciating the profit opportunities. Berkshire is Moody’s biggest shareholder with a 13 percent stake valued at about $1 billion.
Institutional investors and their clients use ratings to set guidelines that determine which bonds can be held in their portfolios, even if they don’t rely on the companies for investment advice, according to Bonnie Baha, head of global developed credit at DoubleLine Capital LP, which oversees $38 billion.
“You have to have some sort of a credible, third-party way to benchmark those categories,” Baha said in a telephone interview from Los Angeles. “The rating agencies are sort of a necessary evil until a better alternative comes along.”
As head of S&P’s structured-finance business, Jacob oversaw the department that rated commercial-mortgage bonds, which are securities composed of loans for office buildings, hotels and shopping centers.
Wall Street has been freezing S&P out from that market since last July, when it withdrew its ratings on a $1.5 billion deal and forced Goldman Sachs Group Inc. and Citigroup Inc. to scuttle the offering after it was sold to investors.
S&P took too long to investigate a possible error that led it to pull its grades, Jacob said. Had S&P acted more quickly on the discrepancy, which turned out not to affect the bonds’ ratings, the deal could have been postponed rather than canceled, he said.
“My frustration was how long it takes to correct it and to figure it out,” Jacob said. Telling investors and bankers that the ratings would be pulled “was probably the most embarrassing and difficult conversation I’ve ever had,” he said.
On Dec. 8, about three months after Peterson took over as president for Deven Sharma, S&P said Jacob would be leaving the company at the end of the year. After thanking Jacob in a statement, Peterson said that Paul Coughlin would take over the structured-finance business temporarily while he reorganized management along regional lines.
“I thought my work wasn’t finished,” Jacob said. He said he’s not sure why he was replaced.
Jacob said he is now considering working in financial regulation. One reform that would improve the quality of ratings would be to have all scores correspond to percentage chances of default, rather than the vague definitions now in use. S&P says its top rating means the issuer is “extremely strong,” while Aaa bonds are considered “highest quality” at Moody’s.
“I was there three and a half years and I still don’t understand it,” Jacob said. “When people can use the same set of letters and mean entirely different things, then they become useless.”
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