McGraw-Hill Facing Fraud Lawsuit Reports S&P Sales at Record

McGraw-Hill Cos., accused by the U.S. of misleading investors about the risks of mortgage bonds that helped ignite the credit crisis, reported the highest sales at its Standard & Poor’s unit since at least 2010, while posting a net loss because of the divestiture of its education unit.

McGraw-Hill reported a revenue increase of 22 percent at its financial operations to $1.23 billion in the fourth quarter, according to data compiled by Bloomberg. The New York-based firm posted a net loss of $216 million as it took a charge on its pending education division sale to Apollo Global Management LLC, classifying the unit as a “discontinued operation.” Bond sales from the U.S. to Europe and Asia climbed 20.4 percent last year to a record $3.96 trillion.

“Bond issuance is humming along,” Ed Atorino, a media analyst at Benchmark Co. in New York who forecasts McGraw-Hill will outperform its peers over the next six to 12 months, said yesterday in a telephone interview. “S&P’s a cash machine.”

The parent of S&P, the world’s largest credit-ratings company, benefited in 2012 as corporate issuers raced to lock in yields at unprecedented lows with the Federal Reserve holding down interest rates to revive the economy. The Justice Department, alleging S&P inflated ratings on mortgage-backed securities and collateralized debt obligations to win business from Wall Street banks, is seeking about $5 billion in penalties, equivalent to more than five years of profit.

‘Extraordinarily Robust’

“The government says that it is seeking more than $5 billion in penalties,” Kenneth Vittor, the company’s chief counsel, said on today’s earnings call. “The complaint includes specifics on only about $500 million.”

“We intend to defend the company vigorously,” Vittor said.

McGraw-Hill reported earnings per share, excluding certain items, of 72 cents and, and it said in a statement that it expects to earn $3.10 to $3.20 per share in 2013. The S&P ratings unit had record sales of $584 million, up from $434 million a year ago.

“The ratings business is extraordinarily robust,” Peter Appert, an analyst at Piper Jaffray & Co. in San Francisco, said in a telephone interview before the report.

Jason Feuchtwanger, a McGraw-Hill spokesman in New York, declined to comment on the company’s performance before the fourth-quarter earnings report. The company said on Feb. 5 the Justice Department’s lawsuit is without merit.

Rising Issuance

Credit raters have benefited as bond issuance has increased with yields on corporate debt from the riskiest to the most creditworthy reaching a record low 3.24 percent on Dec. 28, according to the Bank of America Merrill Lynch Global Corporate & High Yield index.

Moody’s Corp., owner of the second-largest ratings firm, said Feb. 8 that fourth-quarter profit increased 66 percent from the year-earlier period. Net income climbed to $160.1 million from $96.2 million.

Founded in 1888, McGraw-Hill is a Nationally Recognized Statistical Rating Organization, a designation from the Securities and Exchange Commission that allows investors to use its grades to meet regulatory requirements. S&P provided 45 percent of all outstanding ratings in 2011 and has grades on debt from sovereigns to financial institutions, according to an SEC annual report on the industry issued in November.

Reforms Needed

The ratings companies are in need of “fundamental regulatory reforms,” Sheila Bair, a senior adviser to The Pew Charitable Trusts and a former Federal Deposit Insurance Corp. chairman, said today in a Bloomberg Television interview. She questioned why other ratings firms haven’t been sued alongside S&P for alleged fraud.

“I’m not surprised that McGraw is really coming out swinging on this,” Bair said. “This could be their survival.”

A U.S. complaint filed Feb. 4 in federal court in Los Angeles includes at least 58 examples of S&P executives ignoring internal warnings from analysts and others, dismissing relevant data, taking steps to appease issuers or acknowledging how pressure from banks could lessen the quality of its grades or delay downgrades.

Issuers choose rating companies to rate their securities. Fees reached $150,000 for rating a residential mortgage-backed security and $750,000 for a so-called synthetic collateralized-debt obligation, in which the underlying collateral is credit derivatives, including credit-default swaps, according to the complaint.

Share Plunge

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 $12.2 billion today with shares closing at $44.03 in New York trading.

The company’s $400 million of 6.55 percent bonds due November 2037 have dropped almost 12.5 cents from last month to

104.8 cents on the dollar as of yesterday to yield 6.17 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“The issue isn’t going away,” Mark Palmer, an equity analyst for BTIG LLC, a trading firm in New York, said yesterday in a telephone interview. “And frankly, it’s more likely going to get worse because we don’t know how many new additional lawsuits are going to be filed going forward.”

(Updates shares in 17th paragraph. For more on Standard & Poor’s coverage, see EXT3.)
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