S&P Credibility Seen Eroded by Complicity in Soured DealsElliot Blair Smith and Bob Ivry
The mortgage-bond market that David Tesher had described as “a wildly spinning top” was about to tumble when he convened a meeting at Standard & Poor’s Water Street headquarters in New York in March 2007.
Tesher, a managing director, told ratings analysts packed into a windowless 41st-floor conference room that Wall Street clients were under pressure to move souring mortgages into new securities called CDOs before the market crashed. Issuers needed the highest grades on the repackaged bonds to sell them to pension funds, banks and other investors. Tesher’s message, according to a government lawsuit: “Try to be cooperative.”
That same week, in Miramar, Florida, a credit union created in 1937 to serve Eastern Airlines Inc. employees decided to buy some of those CDOs, according to a National Credit Union Administration report. The decision would prove fateful. Within a year, Eastern Financial Florida Credit Union’s entire $149.2 million CDO investment was gone. By June 2009, so was Eastern Financial, a victim of what the government calls a fraud to lower standards and give banks the ratings they wanted.
“We’re in trouble because the rating companies determined where pension funds and others placed their money,” Paul Kanjorski, a former Democratic Congressman from Pennsylvania and member of the House Financial Services Committee, said in an interview. “Once Wall Street made decisions based on deal flow instead of honesty and real profits, it was a terrible thing.”
For decades, S&P and its chief competitor, Moody’s Investors Service, benefited from the government’s blessing as arbiters of creditworthiness. Two attempts by Congress to rein in the raters and probes by a Senate committee and the Financial Crisis Inquiry Commission didn’t change that. Now, the world’s largest ratings firm stands accused of violating its own standards at a moment when judgments free of bias might have reduced economic pain.
The Justice Department lawsuit, congressional records and interviews with former S&P employees provide a road map showing how the firm allegedly lost its way by stifling internal dissent, misleading regulators and accommodating issuers at the expense of investors. The first government fraud case involving a ratings company might set the stage for rule changes that S&P helped block in the past.
A finding against S&P “could be an explosive wake-up call that propels financial reform back to the top of the nation’s agenda, where it belongs,” said Dennis M. Kelleher, chief executive officer of Better Markets Inc., a Washington-based watchdog group, and a former partner at law firm Skadden Arps Slate Meagher & Flom LLP. “Regulators may finally stop listening to Wall Street lobbyists and pass rules to protect taxpayers from reckless and risky betting.”
The Feb. 4 lawsuit seeks at least $5 billion in damages from S&P and its parent, McGraw-Hill Cos., on behalf of federally insured victims including Eastern Financial. No individual is accused of wrongdoing.
The government says the credit union relied on S&P’s assessments in buying pieces of CDOs, or collateralized debt obligations, with names like Pampelonne, Armitage and Corona Borealis that S&P stamped with investment grades, the highest 10 of 22 ratings. In all, S&P rated 218 CDOs worth $145 billion from March 2007 through October of that year, according to Hoboken, New Jersey-based Asset-Backed Alert.
CDOs are collections of assets, such as corporate or mortgage bonds, packaged into new securities. Investors, who get paid when borrowers of the underlying loans pay their monthly bills, can buy different pieces, or tranches, of a CDO. The portions with the most protection against potential losses receive the highest grades from rating companies. CDOs funded the mortgage bubble of the 2000s, and they spread the economic damage when it burst.
The allegations are “meritless,” and S&P will defend itself vigorously, the 145-year-old company said on Feb. 5.
S&P said that since the 2008 financial crisis it has spent $400 million “to reinforce the integrity, independence and performance of our ratings.” The firm said it has brought in new leadership, enhanced risk management and “taken substantive actions to strengthen independence from issuer influence.”
McGraw-Hill shares have tumbled about 19 percent since the government announced the lawsuit.
Tesher’s March 2007 meeting marked the moment when S&P lost its credibility as a provider of “objective, independent, uninfluenced” ratings, according to the government complaint. While banks were in a hurry to push deteriorating mortgages into investors’ hands, the raters were going to “give in” when grading the securities, one unidentified analyst wrote in an instant message after the meeting, according to the lawsuit.
“Deals will rush in before they take further loss,” another analyst wrote in a message cited in the complaint.
Tesher didn’t respond to requests for comment left on his office phone and in an e-mail.
S&P contributed to the building of railroads and auto factories in the 19th and 20th centuries by helping investors gauge the ability of companies to repay their debt. In the early 21st century, Wall Street shifted its emphasis to financial innovations, which included structuring investment funds registered offshore and stuffed with securities linked to subprime mortgages given to people with little or no history of paying their monthly bills. The raters went along.
It was a lucrative business. S&P typically charged issuers $150,000 to analyze pools of mortgage loans, according to the Justice Department complaint. It ran the deals through a loan-evaluation model, and lead analysts then prepared presentations for S&P rating committees, most of which “took less than 15 minutes to complete the reviews,” according to the lawsuit. S&P charged as much as $500,000 to assess CDOs that held much the same collateral and charged $50,000 more to monitor them, the government said.
“We dispute the contention that our review committees were not rigorous,” Ed Sweeney, an S&P spokesman said in an e-mail.
The McGraw-Hill unit that housed S&P generated 48 percent of the company’s $1.7 billion in revenue and 81 percent of the $496.5 million in operating profit before corporate and interest expense in the first quarter of 2007. A 58 percent rise in CDO issuance in the second quarter boosted the unit’s share of that profit measure to 98 percent of the total in the first half, the firm said in a filing.
As early as April 2004, S&P executives quarreled over how much sway issuer banks ought to have. That month, Frank Raiter, who headed the mortgage-securities ratings group, erupted when colleagues suggested S&P invite comment from Wall Street on a proposed toughening of standards.
“Are you implying that we might actually reject or stifle ‘superior analytics’ for market considerations?” Raiter asked in an e-mail reply, according to the government complaint, which identifies him as Executive H. “We NEVER poll them as to content or acceptability!”
Raiter confirmed that he is Executive H. He said he wasn’t copied on subsequent e-mails. He retired the following year.
In the first half of 2004, Tesher and his boss at the time, Richard Gugliada, identified only as Senior Executive D in the government complaint, rejected two new CDO ratings models that would have “damaged” S&P’s market share at different ends of the risk spectrum, according to the lawsuit.
To bridge the gap, Gugliada “fused together” the competing proposals into a formula he named after himself and which his colleagues deemed “indefensible, because it was cobbled together based on considerations of market share and profits, not analytics,” according to the complaint.
Two former colleagues confirmed that Executive D is Gugliada. He was the subject of a September 2008 Bloomberg News article in which he described his role in a “market-share war where criteria were relaxed.” He left the CDO unit in early 2005 and quit S&P the next year, according to interviews with former colleagues and the complaint. Gugliada didn’t respond to requests for comment left at his home and mobile phone numbers and on his personal e-mail.
Even some senior analysts began questioning their bosses about the firm’s practices. In March 2005, Thomas Warrack, an S&P business manager identified only as Executive I in the complaint, proposed temporarily weakening investor protections in a new analytical tool, according to the lawsuit. Frank Parisi, identified as Senior Analyst B, blamed the delay in implementing the changes on pressure “to preserve market share,” the complaint said.
“Screwing with criteria to ‘get the deal’ is putting the entire S&P franchise at risk -- it’s a bad idea,” Parisi wrote in a follow-up e-mail to S&P executives, including Warrack, that was published in a 2011 U.S. Senate investigative report.
Parisi was identified as Senior Analyst B by cross-referencing e-mails cited in the government complaint with those published by the Senate, which didn’t redact his name. Four former S&P employees confirmed that Warrack is Executive I.
Adora Andy, a Justice Department spokeswoman, declined to say why the names of some S&P employees were withheld. Parisi and Warrack, who have not been accused of wrongdoing, didn’t respond to requests for comment.
As Warrack and Parisi discussed trying to balance business and standards, Congress considered ending the special status of credit-rating firms. Insurance companies and pension funds, among others, depend on the assessments of so-called nationally recognized statistical ratings organizations, or NRSROs, to make sure their investments are the highest quality. Some lawmakers argued that getting rid of the designation would open the industry to competition.
S&P lobbyists hit the ceiling, according to a person with knowledge of the discussions. Lobbyists and congressional aides waged shouting matches over the legislation, said the person, who asked not be named because he still deals with S&P.
The resulting Credit Rating Agency Reform Act of 2006 didn’t end the government’s granting of special status. It affirmed it. While the law designated the Securities and Exchange Commission as the primary regulator of NRSROs, it prohibited the agency from overseeing “the substance of the credit ratings or the procedures and methodologies.”
The law did expand the SEC’s ability to oversee the raters’ internal books and records. That provided the legal basis for Justice Department claims that S&P misled the SEC by departing from its own standards of conduct when it applied for renewal of its NRSRO status under the new law in June 2007.
As Congress was debating, Eastern Financial bought its first CDOs in December 2005, including ones that contained corporate bonds, according to a May 2010 report for the inspector general of the federal credit union regulator.
Credit unions are owned by their members and typically make conservative investments. Eastern Financial, the largest such organization in South Florida with $2.2 billion in assets at the time, was the only federally insured retail credit union in the country to own CDOs, the report said.
Stephen C. McGill, who started at Eastern Financial as an accountant fresh out of college 20 years earlier, became CEO in July 2004. He had big plans, including expanding the number of branches to 33 from 18. The region was booming. Southeast Florida’s jobless rate was 5.4 percent, and falling. Home prices had more than doubled over the previous decade.
McGill was a smoker who lifted weights and rode his bicycle 11 miles or more a day, he told the Fort Lauderdale Sun-Sentinel in December 2005. In May 2005, two weeks after completing a 150-mile ride to Key West and back, he suffered a heart attack and collapsed on a treadmill.
“I realized that I should celebrate life every day, because you don’t know how long you will be here,” he told the newspaper.
Eastern Financial, whose headquarters were about 16 miles northwest of Miami, got swept up in Florida’s real estate frenzy. In October 2006, it loaned $30 million to a subsidiary of Merco Group Inc., a family-run developer that planned to build a 338-unit luxury condominium complex in West Palm Beach called Palladio Terrace. The project never broke ground.
When the head of the company, Homero Meruelo, tried to pay a fee to the county to delay foreclosure in April 2008, his $50 check bounced, according to Palm Beach County Clerk and Comptroller’s office. The credit union bought the property out of foreclosure in December 2008 for $100, county records show.
Meruelo died in 2008. Timothy L. Neufeld, an attorney with Neufeld Marks & Gralnek in Los Angeles representing Merco, said the company declined to comment.
“Banks were giving loans to anyone back then,” said Jack McCabe, a real estate consultant in Deerfield Beach, Florida. “What was unusual in this case was that the lender was a credit union.”
From March through June 2007, Eastern Financial bought $94.8 million in subprime-mortgage CDOs, choosing 18 pieces that were investment grade, though not the highest rated, according to the federal credit union regulator.
One of its purchases was a piece of Corona Borealis, a $1.5 billion CDO underwritten by Lehman Brothers Holdings Inc. and named after a constellation. Eastern Financial relied in part on S&P’s rating of the investment in May 2007, according to the government’s case. Corona Borealis, 86 percent of which was subprime mortgage bonds, defaulted nine months later.
Eastern Financial also bought pieces of at least three CDOs originated by Citigroup Inc., according to the complaint and data compiled by Bloomberg.
Citigroup was one of the banks pressuring S&P analysts for more favorable ratings. Edward C. Tang, an investment banker in the New York-based bank’s global capital markets division, warned an S&P analyst in February 2006 that he was “VERY concerned” about the higher bar set by a new CDO ratings model the company was testing, according to an e-mail released by the Senate investigative committee.
“Happy to comply, if we pass, but will ask for an exception if we fail,” Tang wrote.
Tang, who left the bank, declined to comment when reached on his mobile phone, as did Danielle Romero-Apsilos, a spokeswoman for Citigroup.
Robert Morelli, a UBS AG banker, also wrote to S&P, threatening to take the bank’s business to Moody’s or Fitch Ratings, a subsidiary of Fimalac SA of Paris and Hearst Corp., the firm’s two biggest competitors.
“Heard you guys are revising your residential mbs rating methodology -- getting very punitive on silent seconds,” Morelli wrote to an S&P analyst on May 3, 2006, referring to second mortgages, according to an e-mail released by the Senate committee. “May force us to do moodyfitch only CDOs!”
Morelli didn’t respond to a request for comment.
The 119-page government complaint alleges that S&P repeatedly “adjusted and delayed” improvements to its analytical models and “knowingly disregarded the true extent of the credit risks” associated with the CDO investments it rated.
John M. Griffin, a University of Texas finance professor, independently analyzed S&P’s main quantitative model, the CDO Evaluator, which the lawsuit says determined “whether the pool of assets could support the deal’s proposed structure.”
Griffin found that on 916 deals issued for $612.8 billion between January 1997 and March 2007, S&P expanded the AAA rated slices by an average of 12.2 percent beyond what the model specified, according to an article he wrote with University of Hong Kong professor Dragon Yongjun Tang and published in August in the Journal of Finance.
The adjustments exposed CDO investors to lower-grade assets that should have paid $38.7 billion more over the life of the bonds because they were riskier, Griffin said in an interview, identifying S&P for the first time as the company he had analyzed. The adjustments tripled to 18.2 percent in 2007 from 6 percent in 2003 and 2004, Griffin said.
“No one who cares about ratings accuracy would want to copy their model,” Griffin said.
S&P spokesman Sweeney said Griffin’s research was “fundamentally flawed” because it’s based on only one model used by S&P and excludes other components of the ratings process, including a proprietary cash-flow analysis.
“It presents an incomplete and inaccurate description of S&P’s process for rating” the investments, Sweeney said.
By the end of 2006, the chance to slow Wall Street’s runaway mortgage machine was slipping away. Executive F, identified by four former colleagues as Ernestine Warner, complained to her boss in a Nov. 14, 2006, e-mail that more than 50 percent of the subprime deals S&P had rated that year had “severely delinquent loans,” according to the Justice Department lawsuit. Warner, whose job was to keep an eye on the performance of mortgage deals S&P had already rated, attached a spreadsheet to her message as proof.
Warner, now a senior S&P investor-relations director, did not respond to e-mails or telephone messages left at her home.
“This market is a wildly spinning top that is going to end badly,” Tesher, managing director for cash CDOs, wrote in his confidential working notes in December 2006, according to the government lawsuit.
It ended badly for banks such as Citigroup and Bank of America Corp., which were named as victims in the lawsuit even though they created some of the CDOs that S&P rated. The Justice Department sued S&P under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which prohibits fraud against financial firms that receive government insurance.
Citigroup put together Ridgeway Court Funding II Ltd. after going “negative on subprime” in late 2006, Thomas Maheras, former co-CEO of Citi Markets and Banking, said at a hearing of the Financial Crisis Inquiry Commission in 2010.
“We were, in most of our business areas, reducing our risk around subprime,” he said.
Citigroup was reducing its risk, in part, by passing it along to Eastern Financial. Portions of the three Citigroup CDOs the credit union bought -- Ridgeway Court, Armitage ABS CDO Ltd. and Stack 2007-1 Ltd. -- had received investment grades from S&P, according to data compiled by Bloomberg.
The ratings didn’t survive a year. Armitage and Stack both went bust in December 2007, and Ridgeway Court defaulted a month later, 26 weeks after S&P told the world it was as safe as U.S. Treasury bonds, which have, so far, never quit paying.
S&P continued fiddling with its methodology to come up with ways to placate bankers, according to the government complaint.
On May 10, 2007, a business manager identified as Executive J in the lawsuit proposed “A Better Mousetrap” strategy to produce “business-friendly” ratings that were also “plausible,” according to the complaint.
The manager, Elwyn Wong, is identified by his last name in a separate lawsuit against S&P filed by the California attorney general and containing many of the same allegations. His first name was confirmed by a person with knowledge of his identity who asked not to be identified because he wasn’t authorized to discuss it. Wong hasn’t been accused of wrongdoing.
The market collapsed before S&P could implement its new mousetrap, according to the lawsuit. Wong, who now works for the U.S. Office of the Comptroller of the Currency, declined through an agency spokesman to comment.
While defaults were rising and funds created by New York-based Bear Stearns Cos. and BNP Paribas SA in Paris that contained subprime mortgages were failing, S&P was rating more CDOs than ever.
What the Justice Department called “the implosion” produced “the highest monthly deal volume ever, doubling the total from the previous two months,” S&P CDO executive Patrice Jordan e-mailed her boss, Executive Managing Director Joanne Rose, in May 2007, according to the lawsuit. The next month, S&P rated 30 CDOs, backed in part by subprime-mortgage bonds, priced at more than $27 billion, the complaint said.
In July 2007, some analysts suggested S&P temporarily halt ratings of new CDOs. Tesher, the managing director, said the firm couldn’t “close the window” as issuers cleared their books of defaulting mortgages, according to the complaint.
The losses on CDOs, combined with its real estate lending mistakes, devastated Eastern Financial. McGill, the CEO, left in February 2008, a month after the credit union’s third and last Citigroup CDO defaulted. He tried his hand at selling distressed properties, according to a real estate company website.
In April 2009, Eastern Financial was put under conservatorship, and in June of that year merged with Melbourne, Florida-based Space Coast Credit Union. Total hit to the agency’s deposit-insurance fund: $40 million.
“Investing in CDOs wasn’t a decision I would have made, but that doesn’t mean they didn’t have a good reason for doing what they did,” said Kent Herbert, who preceded McGill as Eastern Financial CEO and retired in 2004. “This is how it’s presented to you: Very good return, a high S&P rating. I can see why somebody would choose it.”
An autopsy conducted by the federal credit union regulator found that Eastern Financial’s management and board relied too heavily on the assessments of ratings firms.
“This isn’t a story of an innocent grandma who gets snookered by big city bankers,” said Ken Thomas, a Miami-based bank consultant and economist. “These guys at Eastern Financial were the high rollers of the credit-union world. They could have made money the traditional way, but they wanted to make more.”
McGill couldn’t be reached for comment. Calls or e-mails to former board chairman Peterjohn Plummer, board members Edwin E. Feathers Jr. and George Nikitin, former Chief Investment Officer Kendrick Smith and former senior vice presidents James Pavlonnis and Gary Lanier, weren’t returned.
“I miss Eastern Airlines to this day, and the credit union was awesome, too,” said Shelia Filos, who worked as a flight attendant from 1979 to 1991, when the carrier folded, and now lives in Flowery Branch, Georgia.
Congress tried once more, in 2010, to limit the influence of credit-ratings companies. The Dodd-Frank Act, signed into law that year, aimed to reduce reliance on ratings, address conflicts of interest and increase disclosure.
The SEC had earlier ruled that S&P, Moody’s and the other NRSROs couldn’t be held liable for the quality of their ratings because they were opinions protected by the U.S. Constitution’s guarantee of freedom of speech.
Dodd-Frank overturned that protection. In July 2010, the same month the law passed, Ford Motor Credit Co. informed the SEC that it couldn’t find an NRSRO willing to issue ratings for asset-backed securities it planned to sell because of the change. Without ratings, the market for asset-backed securities was in danger of freezing.
The SEC, in a November 2010 “no-action letter” posted on its website, said it wouldn’t require issuers of asset-backed securities, such as Ford, to include the ratings for which the NRSROs might be held liable.
“The ratings companies were regularly able to hold market players, regulators and lawmakers hostage, even neutering necessary portions of Dodd-Frank to their benefit,” said Joshua Rosner, an analyst at Graham Fisher & Co. in New York.
The 2006 credit-rating act and Dodd-Frank have “improved transparency and increased the competitive landscape, which we welcome,” said Sweeney, the S&P spokesman.
Demand for corporate ratings is higher than ever. Companies issued a record $3.97 trillion of bonds in 2012, data compiled by Bloomberg show. Rating those securities increased S&P’s revenue to $2 billion last year, the highest level since at least 2009. S&P, Moody’s and Fitch provided 96 percent of all grades in 2011, according to a November SEC report.
Few of those ratings were stamped on CDOs. After analyzing 1,220 deals priced at $630 billion from 2004 to 2007, S&P has rated just seven of the 42 CDOs issued in the U.S. since 2008, according to Asset-Backed Alert.
On Feb. 5, a day after the Justice Department filed its complaint, the state of California sued S&P on behalf of public pension funds, making claims similar to the federal lawsuit.
According to the California attorney general, S&P held a leadership meeting in June 2011 with the theme “Relentlessly Driving Global Growth.” Among the messages executives tried to impart to subordinates: Success in developing ratings criteria depended on “ongoing collaboration between the criteria group and the business.” Participants were given a case study involving raters who didn’t cooperate with business.
“Even today,” the California complaint said, “S&P continues to resist reform.”
The case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los Angeles).