Rating Victims Didn’t Know S&P’s Toxic AAA Born of Greed
When Charles O. Prince III was chief executive officer of Citigroup (C) Inc. from 2003 to 2007, he didn’t know about a surge in mortgage risk that his own investment bankers loaded on to its bank’s books.
Because such debt carried top credit ratings from firms such as Standard & Poor’s, few financial executives paid attention to the potential dangers.
“If someone had elevated to my level that we were putting, on a $2 trillion balance sheet, $40 billion of AAA rated, zero risk paper, that would not in any way have excited my attention,” Prince told the Financial Crisis Inquiry Commission, according to a transcript of his testimony released in 2011.
Mortgage securities granted top grades started souring in 2007, leading to ballooning losses. Citigroup required a $45 billion federal rescue, the largest of the bank bailouts that put taxpayer money at risk. The Justice Department sued New York-based S&P and parent McGraw-Hill Cos. last week over the damage caused by the practices allegedly behind the inflated rankings that contributed to the biggest financial crisis since the Great Depression.
Some of the biggest losers were banks, including Citigroup and Bank of America Corp. (BAC), which created and purchased collateralized debt obligations. Many of these investments -- created by packaging mortgage-backed bonds, derivatives and other CDOs and dividing them into new securities with varying degrees of risk -- imploded within a year after they were sold, even though they had pristine credit ratings.
Smaller financial institutions were also ruined by mortgage-backed debt. Western Federal Corporate Credit Union failed after its executives employed an improperly “aggressive investment strategy” that had no limits on highly rated mortgage bonds, according to a regulatory report on its collapse.
Even Warren Buffett was affected. The Justice Department case identified Buffalo, New York-based M&T Bank Corp. (MTB), whose shareholders include Buffett’s Berkshire Hathaway Inc. (BRK/A), as one of the buyers of failed CDOs. Berkshire of Omaha, Nebraska, is also the biggest shareholder of Moody’s Corp. (MCO), owner of the second-largest ratings firm after S&P.
The world’s leading financial institutions suffered more than $2.1 trillion of writedowns and losses after soaring U.S. mortgage defaults caused the credit crunch.
In the complaint filed Feb. 4 in U.S. District Court in Los Angeles, the Justice Department is invoking a law created in response to the savings-and-loan crisis of the 1980s that was designed to offer easier victories when damage has been done to institutions with federally insured deposits.
Success is “far from clear,” Jeffrey Manns, an associate professor at George Washington University Law School, said Feb. 7 in a telephone interview. S&P may argue it believed in its ratings or the statute doesn’t apply to the case.
“We start with proposition that we deny there was any fraud,” Floyd Abrams, the Cahill Gordon & Reindel LLP lawyer for S&P who represented the New York Times in the 1971 Pentagon Papers case, said in a telephone interview on Feb. 7. Fraud claims have “a high burden of proof,” he said.
Ed Sweeney, a spokesman at S&P, declined further comment.
McGraw-Hill’s market capitalization, which reached a five-year high of $16.2 billion at the start of the month, has plunged since the company said it anticipated the lawsuit would be filed, reaching $11.9 billion at the end of last week.
The company’s stock price declined 27 percent in the five-day period ended Feb. 8 to $42.67, the biggest weekly drop in data compiled by Bloomberg going back to August 1980. The yield on its 2017 bonds leapt 69 basis points to 2.69 percent. The cost of insuring its debt against non-payment through five-year credit-default swaps jumped 135 basis points to 225.5 basis points, according to data provider CMA. McGraw-Hill owns CMA, which compiles prices quoted by dealers in the private market.
Citigroup underwrote at least eight of the 12 CDOs from 2007 named in the government’s complaint for which it’s listed as a victim. That included Bonifacius, an issue among the last of its type named for a general called the “last of the Romans” by historian Edward Gibbon because he fought and died for a fading empire.
Prince, who was forced out over New York-based Citigroup’s mortgage losses, didn’t return an e-mail last week.
Charlotte, North Carolina-based Bank of America, the second-largest U.S. lender by assets, hired S&P to grade two of the three CDOs for which it’s named as a victim, including one overseen by Bear Stearns Cos.’s Ralph Cioffi, the manager of two hedge funds whose collapse in June 2007 signaled the end of the boom in mortgage-tied CDOs. Bear Stearns collapsed in 2008 and was bought by JPMorgan Chase & Co. (JPM), the largest U.S. bank, with assistance from the Federal Reserve.
Underwriters of CDOs typically signed off on the contents of the deals and the nature of disclosures regarding their risk. Pressure from such firms pushed S&P to weaken its standards and to put off changes in ratings methods that could have made it tougher to receive top rankings, the Justice Department said.
Even though the Justice Department lawsuit relies on examples where the same banks sold and bought their own toxic securities, saying they were harmed by S&P “isn’t a totally ridiculous assertion,” said Bert Ely, an Alexandria, Virginia-based bank consultant.
“One of the things you’ve got to realize about large financial institutions is that they’re big organizations, they’ve got lots of different departments,” he said in a telephone interview. “So the left thumb doesn’t know what the right finger is doing, much less the right big toe.”
While no bank or regulator should have had a “blind reliance on ratings,” the correct, lower grades might have prevented risks from building, Thomas Stanton, a former senior staff member at the financial crisis commission, or FCIC, said Feb. 7 in a telephone interview.
“If we were in an era where rating agencies were simply incompetent and the investors failed to do due diligence, that’s one thing,” said Stanton, a Washington attorney and fellow at Johns Hopkins University’s Center for the Study of American Government. “But what seems to be coming out is a potentially higher level of culpability at S&P.”
Federal prosecutors allege that S&P didn’t adjust its analytical models or take other steps it knew were necessary to reflect the risks of the securities. The claims are tied to whether the company accurately represented the care it took in providing credit grades and avoiding conflicts, not how incorrect its ratings later proved. E-mails and other internal documents show executives were concerned that tougher standards would cause issuers to take their business elsewhere.
High ratings were critical to encouraging banks to invest in mortgage securities, Chris Whalen, executive vice president at Carrington Investment Services LLC, said Feb. 7 in a telephone interview.
“A bank could not have bought the securities but for the rating” said Whalen, a former managing director at Institutional Risk Analytics, which evaluates banks for investors. That’s because their capital rules “were totally ratings driven.”
Western Corporate Federal Credit Union, or WesCorp, was seized by its regulator in 2009 after almost $7 billion in losses from investments in mortgage bonds with AAA or AA ratings.
Like other so-called corporate credit unions that provide services to credit unions that deal with consumers, it was “only allowed to invest in highly rated securities,” according to a regulatory report on its failure.
While the Justice Department called San Dimas, California-based WesCorp a victim of S&P, the National Credit Union Administration said in 2010 in a lawsuit against 15 of its former directors and officers that they had been “grossly negligent” in overseeing the bank. There had also been improper payments from certain executive retention plans, according to the lawsuit filed in federal court in Los Angeles.
Robert A. Siravo, its former CEO, agreed to pay $600,000 and was banned from working at credit unions to settle NCUA claims, the regulator said in October. He didn’t admit liability or fault.
Credit unions now pay special assessments to cover the losses on failures of institutions including WesCorp. Those costs may translate to lower savings rates to consumers.
Other victims named by the Justice Department included Eastern Financial Florida Credit Union, which was created for Eastern Airline Transport Co. employees and their family members in 1937 and failed in 2009. Also identified were units of M&T Bank, the lender that repaid more than $700 million in Troubled Asset Relief Program, or TARP, funds in 2011, and Chicago-area First Midwest Bancorp Inc.
The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 that the Justice Department is using to sue S&P stemmed from the savings-and-loan crisis of the 1980s, when the failure of about 750 thrifts cost taxpayers almost $90 billion.
“Firrea was the Dodd-Frank of its day,” Cliff Rossi, executive-in-residence at the University of Maryland’s Robert H. Smith School of Business, said Feb. 7 in a telephone interview, referring to the financial-overhaul law enacted in 2010.
Because Citigroup and Bank of America created some of the CDOs, Rossi said he “found it a little surprising they would try to come at it like these were some unfortunately aggrieved institutions.” Still, the history of why Firrea included tougher enforcement powers reflected the view at the time that thrift executives had often worked with other parties to put their own firms and, ultimately, taxpayers at risk, he said.
“A lot of what happened had had nothing to do with looking after the best interest of shareholders and instead about looking after the best interest of senior executives,” Rossi said.
The FCIC, which was created by Congress with a 10-member bipartisan board in 2009, said in its final report that Citigroup’s “willingness to use” its bank “to support the CDO business had the desired effect” of boosting it from the 14th ranked underwriter in 2003 to second place in 2007.
In a 2008 letter to Vikram Pandit, Prince’s successor, the Federal Reserve Bank of New York criticized how Citigroup offered its various units “largely unchallenged access to the balance sheet to pursue revenue growth.” Pandit was ousted in October by Citigroup directors.
In turn, “what was good for Citigroup’s investment bank was also lucrative for its investment bankers,” the FCIC said. The co-heads of its global CDO business each made about $6 million in 2006, while a co-CEO of the investment bank earned more than $34 million in salary and bonus.
Taxpayers were forced to offer the bank the $45 billion bailout, later repaid, as part of the $700 billion TARP.
“I know it sounds like the bank robber who gets held up by someone else,” said Ely, the banking consultant. “But bad guys can still be victims of a crime.”
The case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los Angeles).
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