Ratings Inflation Is Back, Subprime StyleBy
AT&T’s bid to buy Time Warner just the latest mega-deal
Moody’s, S&P go beyond financial metrics on acquisitions
A decade after the triple-A failures of the subprime era, grade inflation is back on Wall Street.
Over the past year and a half, both have bumped up their ratings by two, three or even six levels on a majority of the biggest deals, the analysis found.
Moody’s and S&P don’t dispute those findings, which are based on ratings guidelines posted on their websites. But the firms say a by-the-numbers approach overlooks one of their most valuable assets: human judgment. Both make clear that their analysts have leeway to nudge ratings up or down, based on a company’s track record and their confidence in management’s commitment to reduce indebtedness.
“We want our analysts and committees to get behind the story and make their judgments about what they think the organization will look like in the next couple of years,” says Mark Puccia, a chief credit officer at S&P.
Says Stephanie Leavitt, a spokeswoman for Moody’s: “The evaluation of financial metrics alone provides an incomplete view of credit risk to investors.”
Some investors warn the approach has encouraged an epic debt binge that could pose dangers as years of near-zero interest rates come to an end. AT&T’s plan to borrow about $40 billion to buy Time Warner Inc., in addition to its $120 billion of debt already outstanding, is just the latest example. In 2015 alone, U.S. companies borrowed a record $1.6 trillion in the bond markets, with $258 billion of that going to finance acquisitions by investment-grade companies, Barclays Plc says. According to Morgan Stanley, corporate America is now more leveraged than ever.
“You have some very large companies that are getting the benefit of the doubt from ratings agencies and from the market,” says Jerry Cudzil, head of U.S. credit trading for TCW Group, which manages $197 billion in assets. “The longer this goes on, the higher the likelihood that all of that leads to not only financial losses but to a significant slowdown in the economy and ultimately a recession.”
Granted, not even die-hard pessimists say rosy ratings are about to unleash a full-blown crisis. But it was only a few years ago that Moody’s and S&P were criticized for having stamped gilt-edged grades on iffy mortgage investments. Last year, S&P was fined $1.5 billion, and Moody’s said last week that it faces a U.S. government lawsuit over grades given to securities backed by home loans. Now, by giving some corporations wiggle room to borrow for M&A, Moody’s and S&P have helped executives seal deals and borrow vast sums of money.
Post-crisis legislation required credit-rating companies to be more transparent about their ratings methodologies. Those methodologies are just a starting point, however. If ratings analysts are confident an acquirer will pay its debts, the argument goes, that confidence should be reflected in the grades. What’s more, investors expect ratings to reflect long-range views, not Wall Street’s latest whims, the firms say.
All of which may be fine for bond investors -- unless companies start to struggle under the weight of this new mountain of debt. “When you start talking about the qualitative factors, you’re stepping into an area that’s by nature fuzzy,” says Scott McCleskey, a former Moody’s chief compliance officer who testified to Congress in 2009 against his former employer, saying Moody’s failed to properly monitor municipal-bond ratings. “You’re building assumptions on top of assumptions. It’s all scientific guessing.”
How much does human judgment shade corporate ratings? One way to answer that question is to compare two credit scores -- the grades corporate acquirers would have received based solely on financial metrics and the ones they actually got.
Bloomberg examined U.S. deals with values of at least $10 billion, excluding financial firms and utilities, that were announced in the 18 months ended June 30 and funded with debt.
Both Moody’s and S&P rated 32 such transactions. At Moody’s, 27 of the ratings were higher than the ones the firm typically assigns to companies with comparable debt loads. At S&P, 17 out of 32 of the acquiring companies got higher ratings.
In Moody’s case, no company received a rating that was lower than the metrics suggested. In other words, Moody’s bumped many ratings up, but none down.
S&P assigned lower ratings to four of the companies.
“Sometimes the ratings agencies give companies the benefit of the doubt that they can achieve the debt reduction that the company has articulated,” said Joel Levington, a former S&P director and now head of credit research for Bloomberg Intelligence.
While neither Moody’s nor S&P took issue with those numbers, both emphasized they’re upfront about how their analysts exercise judgment.
Moody’s says its ratings reflect dozens of factors, ranging from a company’s size to its brand strength to its willingness to innovate, as well as familiar financial measures such as its leverage ratio. It makes plain that “forward-looking expectations” can influence ratings.
Moody’s analysts often assign ratings that differ from what its hard metrics might indicate, according to Mariarosa Verde, a senior credit officer. “The committee uses its own judgment,” she says.
S&P evaluates a company’s ability to repay debt, referred to as financial risk. It compares that with the company’s business risk, which factors in things like the company’s profitability and how competitive it is relative to peers. Where the two risk factors intersect on a matrix determines the rating, according to S&P’s website.
In its analysis of S&P, Bloomberg used the business-risk labels that S&P established and plotted it against S&P’s benchmark for financial risk. Bloomberg found that in more than half the deals, the companies had gotten ratings that didn’t line up with the matrix.
In looking at M&A, S&P says it encourages its analysts to take stock of management’s credibility, the reasons for doing a deal and the company’s record with acquisitions, as well as its plans for structuring and financing the combined companies. According to its website, S&P’s methodology allows for committees to assign ratings that are one level above or below what the guidelines suggest.
With some recent M&A deals, however, the firms stretched further. Here are examples:
-Dell Inc.’s debt relative to earnings after the September purchase of EMC Corp. warranted a rating as low as the Caa band, one of the lowest rungs of speculative grade, from Moody’s, the Bloomberg analysis found. Moody’s rated the company Ba1, six notches higher.
-Charter Communications Inc. received a BB+ grade from S&P after it announced its purchase of Time Warner Cable Inc. Using S&P’s estimate of the company’s future leverage levels, its view of the company’s business risk and taking into account Charter’s $60 billion of debt, the rating should’ve been BB-, two notches lower, according to Bloomberg’s analysis. In 2009, Charter went into bankruptcy under the weight of $21 billion in debt.
-Newell Brands Inc., maker of Rubbermaid, deserved a junk-grade between B and Ba from Moody’s after it agreed to buy Jarden Corp., based on a leverage ratio that was about double its peers with similar ratings, the analysis found. Moody’s gave it an investment-grade Baa3.
-Kraft Heinz Foods Inc.’s leverage ratio and S&P’s assessment of management justified a downgrade to as low as BB-, a junk rating, the analysis found. S&P gave it an investment grade of BBB-, three notches higher.
-In June, S&P blessed Microsoft Corp.’s $26 billion purchase of LinkedIn Corp. with its highest rating. It cited Microsoft’s “long history of making investment decisions in a fiscally prudent manner” -- even though Microsoft had just written down nearly the full $9.5 billion value of its 2014 purchase of Nokia Corp.’s mobile-phone unit.
Ratings officials say that deals that hurt a company’s credit health don’t always result in downgrades if analysts believe the impact will be temporary.
“If you have a seasoned management team that’s done this before, it’s a different consideration than if you have new managers with no track record,” Verde of Moody’s says.
In some instances, Wall Street analysts have taken issue with the ratings firms. For instance, not everyone thought Moody’s and S&P went far enough when they downgraded Teva Pharmaceuticals Industries Ltd. by one notch after the drug company agreed to buy Allergan Plc earlier this year for $40.5 billion.
“The rating agencies have gone easy on the company,” Carol Levenson, an analyst at Gimme Credit, wrote in a July report.
While drug companies like Teva typically generate enough cash to pay their debts, the ratings companies were taking a leap in concluding that Teva’s management would refrain from acquisitions in the future, she said.
“Where faith comes into the picture is believing that management will choose to use every penny of free cash flow to reduce debt,” Levenson wrote.
Most people agree that credit ratings are part art and part science. S&P analysts often give high-rated companies more latitude in deal-making than low-rated ones, since high-rated companies are supposed to be financially stronger to begin with, according to its methodology.
But back in 2008, when the last crisis struck, some companies that received investment grades from Moody’s defaulted more frequently than those at the high end of the junk-bond market. The same thing happened with S&P in 2009. The ratings companies, in other words, had underestimated the risks.
This time around, some bondholders have already lost money, at least on paper.
Like many on Wall Street, Moody’s misread Valeant Pharmaceuticals International Inc., which has seen rocky times following a series of debt-fueled takeovers. Moody’s maintained its ratings as the company’s debt ballooned, citing Valeant’s “successful acquisition track record.” Over the past year, investors who hold Valeant’s most actively traded bond have lost about 8 percent, according to data compiled by Bloomberg.
Likewise, Perrigo Co. received higher credit scores because S&P said it trusted management to reduce the generic drugmaker’s indebtedness, even after Chief Executive Officer Joseph Papa increased it with another acquisition. Last year, Perrigo bonds were the second-worst-performing of investment-grade health-care companies with dollar-denominated debt in the Bank of America Merrill Lynch U.S. Healthcare Index.
“There has to be judgment to give real value to ratings,” says Adam Zurofsky, a former senior adviser at S&P, who was speaking generally and not about any specific deals. “But that judgment has to be exercised responsibly.”
Says David Horsfall, deputy chief investment officer at Standish Mellon Asset Management Co. in Boston: “This all works until the market says, ‘No thank you, that’s too much debt.’ ”
Regulators need to keep a close eye on the credit-rating companies, said U.S. Senator Al Franken, a Minnesota Democrat. “The practice of routinely raising ratings based on subjective factors certainly deserves scrutiny.”
— With assistance by Matt Scully