When Credit Ratings Lose Their Meaning
Which is a safer investment: (A) Treasury bonds, backed by the full faith and credit of the U.S. government, or (B) securities backed by subprime loans, the same type of investments that led to the worst financial crisis since the Great Depression? For ratings company Standard & Poor’s, the answer is B.
S&P stripped the U.S. of its top grade, AAA, on Aug. 5, saying Washington politics was making the country less creditworthy. Meanwhile, the company has stamped AAA on more than $36 billion of U.S. securitized debt this year, according to data compiled by Bloomberg. Overall, some 14,000 securitized bonds, backed by everything from houses and malls to auto-dealer loans, carry the AAA rating from S&P. They are created by bankers who gather thousands of loans, package them into bonds, slice them into pieces of varying risk, and pay ratings firms a fee to evaluate them. S&P is not paid for rating U.S. government debt.
S&P justified its downgrading of the U.S., which, unlike corporations, has the authority to set tax rates and print money, by saying politicians are becoming “less stable, less effective, and less predictable.’’ That logic puzzles some investors. “I’m trying to sort out why debt backed by the ability to tax in the United States is rated lower than securities that are backed by no particular ability to have additional revenue,” says John Milne, who oversees about $1.8 billion as chief executive officer of JKMilne Asset Management in Fort Myers, Fla.
In addition, the ratings discrepancy implies that some securitized debt could survive a default by the U.S. government. That’s hard to believe, says Satyajit Das, author of Extreme Money: Masters of the Universe and the Cult of Risk. “If the sovereign goes down the tubes,” says Das, “it’s very difficult to see how these structures will be unaffected.’’
S&P, a subsidiary of educational publisher and financial data company McGraw-Hill, hasn’t stopped handing out AAAs. It’s giving its top rating to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties, according to potential investors who declined to be identified because the deal is private. Granting top grades to securitized debt can be appropriate as long as the AAA-rated portion is small enough that the collateral is sure to be worth enough to pay it off even in extreme circumstances, says Ron D’Vari, the chief executive officer of the NewOak Capital. He used the example of $100 of bonds backed by $500 million of car loans—a far different ratio than in the Springleaf offering. “We didn’t even start to look at the deal,” says Paul Norris, a senior money manager at Dwight Asset Management in Burlington, Vt. “For the funds we would buy this in, we need an AAA rating, and we don’t have any confidence S&P would hold this rating for any period of time.”
The Senate’s permanent subcommittee on investigations said in April that S&P, Moody’s Investors Service, and Fitch Ratings helped inflate the mortgage bubble by engaging in a “race to the bottom’’ to assign top ratings to risky securities. Even since the crisis, S&P has admitted to a string of mistakes in rating structured-finance products, including misunderstanding cash flows and using conflicting methods to analyze the securities. “These are errors that could cause airplanes to crash if this was aerospace engineering,” said Sylvain Raynes, a principal at R&R Consulting in New York and a former Moody’s analyst.
In July, S&P said that it allowed a discrepancy to develop between how it rated commercial-mortgage securities before and after they were issued. The problem came to light in connection with $1.5 billion in bonds that Goldman Sachs and Citigroup were planning to offer, when investors objected to the amount of the deal getting an AAA rating. After S&P discovered the problem, it withdrew its ratings on the bonds, and Goldman Sachs and Citigroup had to withdraw the deal. “Our pursuit of quality and comparability means that when we discover a material error in our ratings, we promptly review it and address the matter transparently,” says Ed Sweeney, a spokesman for S&P.
S&P President Deven Sharma, who’s stepping down this month, has defended the company’s credit analysis since taking over in 2007. “Clearly, there were many lessons we learned out of the U.S. residential mortgage-backed securities,” Sharma told Congress in July. S&P reviewed its methodologies and added checks to make sure ratings are “completely comparable” across asset classes and regions, he said. S&P said on Aug. 22 that Sharma will be replaced by Citibank COO Douglas Peterson.
Investors still don’t trust that S&P’s sovereign and structured-finance ratings are consistent. Normally, bond buyers demand higher yields as compensation for holding riskier debt. Yet the yield on Treasuries has plunged since the downgrade. Now, top-rated portions of recently issued commercial-mortgage-backed securities pay yields of 3.66 percent, or almost three times as much as U.S. government debt rated one step lower by S&P, according to Barclays Capital index data. “Everybody has been led to believe over the years that AAA means AAA means AAA across the board,” says Gregory W. Smith, the general counsel for the $41 billion Public Employees’ Retirement Association of Colorado. Money managers who still believe that, he says, “should find another line of work.”