Let's never let S&P forget the person who said that they'd rate a deal "structured by cows."

Photographer: Justin Sullivan/Getty Images.

S&P Got a Little Casual With its Mortgage Ratings

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Here's a story that the Securities and Exchange Commission tells about Standard & Poor's 2010 holiday party. Specifically, it's about Barbara Duka, the managing director in charge of S&P's ratings of commercial mortgage-backed securities at the time, who wanted to make a change to S&P's ratings methodology:

At S&P’s holiday party, she and one or two other members of the CMBS Group approached the new CMBS criteria officer, who had just joined S&P earlier on the same day, and pushed him to agree to use blended constants. When he demurred, Duka approached the chief of S&P’s structured finance criteria organization with the same request early the next morning. After a brief meeting, Duka unilaterally concluded that she had obtained his approval for use of the blended constants, but she made no record of the meeting or this decision. 

We'll get to blended constants in a moment, but don't you just love this scene? For one thing, I mean, what a fun party. And ambushing the new guy at a party on his first day to get him to sign off on your aggressive changes is really just such a power move. Herodotus says of the Persians:

It is also their general practice to deliberate upon affairs of weight when they are drunk; and then on the morrow, when they are sober, the decision to which they came the night before is put before them by the master of the house in which it was made; and if it is then approved of, they act on it; if not, they set it aside. Sometimes, however, they are sober at their first deliberation, but in this case they always reconsider the matter under the influence of wine.

I was pleased to learn that this was also the practice at S&P.

Today the SEC fined S&P a total of $58 million -- and two state attorneys general took another $19 million -- for doing an assortment of bad stuff in its rating of mortgage-backed securities. The SEC is also suing Duka personally  for, basically, being awesome at parties.

Standard & Poor's is perhaps best known for giving bad ratings to residential mortgage-backed securities before the financial crisis, and the big lawsuit over that is ongoing, but today's fines are mostly for commercial mortgage-backed securities ratings, and are for post-crisis behavior, not for getting the global financial crisis wrong.

Actually one of the fines is for S&P getting the Great Depression wrong. The idea is that S&P wants an "AAA" rating to mean that a security would survive the Great Depression. That is a good thing to advertise, but it does sort of require you to figure out how the security would have done in the Great Depression. That is in a sense a silly question, but in 2012 S&P went and did it for commercial mortgages, publishing an article called "Estimating U.S. Commercial Mortgage Loan Losses Using Data From The Great Depression." The SEC has some complaints about the article:

The Great Depression Article was flawed, in part because it suggested “about 20%” losses in periods of “extreme economic conditions” without adequately disclosing certain significant assumptions, including the following:

a) S&P’s analysis of purported Great Depression losses and defaults included analysis of performance of commercial mortgages originated between 1900 and 1935, many of which were not affected by the extreme economic stress of the Great Depression;

It goes on. This one cost S&P $15 million. Fifteen million dollars, for getting its history wrong.

The big fine, though -- $42 million to the SEC -- stems from the "blended constant" stuff that Barbara Duka tried to push through at that party. This had to do with how S&P calculated the debt service coverage ratio, a measure of whether a commercial building generates enough money to pay off its debts with some room to spare. This ratio fed into S&P's estimate of default likelihood, and thus into how conservative, or not, its ratings were.

Conceptually, the way you calculate debt service coverage ratio for a property is:

  • You figure out how much cash the property will generate every year.
  • You figure out how much the property owner will have to pay back on its loans every year.
  • You divide the first number by the second number.

The SEC has no problems with how S&P calculated the numerator, the future cash flow.  The denominator -- the debt service cost -- is where S&P ran into trouble. This is a bit weird, because unlike the numerator -- future cash flows -- this is just a number that you can know. You're rating a loan. You know how big it is. You know its interest rate.   You know its amortization schedule. From that, you can figure out how much the building's owner has to pay each year on the loan. 

But S&P does some arithmetic manipulation: Instead of [Cash Flow divided by Debt Service], it calculates the coverage ratio as [Cash Flow divided by (Loan Constant times Loan Amount)]. Naively, the loan constant is just the debt service divided by the loan amount, so it should all cancel out. You can convert any loan payment into a "loan constant." Just for fun I calculated the loan constant on my mortgage. It's 6.44 percent. So if I had a $1 million mortgage, I'd be paying $64,400 a year in interest and principal. 

Here's the methodology I used to calculate the loan constant on my mortgage:

  1. Take my yearly payment, and divide by the original principal amount of my mortgage.

Easy! Here's the methodology S&P used to calculate its loan constant, before its holiday party:

  1. Take the yearly payment, and divide by the original principal amount of the loan. (This is called the "actual constant.")
  2. Take an arbitrary number from Table 1 on page 5 of this 2009 publication, 7.75 percent to 10 percent, depending on the property type. (The SEC calls this the "criteria constant" or "Table 1 loan constant.")
  3. Use whichever is higher. 

I mean ... I guess? The arbitrary numbers tended to be higher than the actual numbers, and a higher loan constant gets you a lower debt service ratio, and a lower debt service ratio gets you a lower rating. So this methodology was conservative. On the other hand, it's maybe a little weird? To just use an arbitrary number?

Duka pushed to change the methodology to a "blended constant" model, which worked like this:

  1. Take the yearly payment, and divide by the original principal amount.
  2. Take the arbitrary number from that Table 1.
  3. Take the average of #1 and #2 to get a third, literally semi-arbitrary number.
  4. Take whichever of #1 and #3 is higher.

So now, if the arbitrary number was higher than the actual debt service, it would only have half as much impact as it did before. This was a change! Toward ... accuracy? I don't even know. 

S&P's sins here were twofold. One problem is that its disclosure of the change was at best unclear, and at worst misleading: For a while, it was rating transactions using the "blended constant" methodology, while publishing presale reports calculating debt service coverage ratios using the old, more conservative methodology.

The bigger problem is just that S&P's motives were impure, or at least its e-mails were. Ratings agencies are businesses, but they have to pretend that their ratings are entirely unmotivated by business considerations. So this is the sort of paragraph that the SEC glories in writing:

Duka was aware of and concerned about S&P’s low market share and blamed it in part on her perception that S&P’s CMBS criteria were producing CE levels that were too high for S&P to get rating assignments from CMBS issuers. In an email dated October 11, 2010, Duka wrote that “we looked at and lost [a CMBS new issue] because our feedback was much more conservative than the other rating agencies.” In an email dated November 11, 2010, Duka wrote that S&P’s “more conservative criteria . . . could impact the business” and were among the “key challenges” facing the CMBS Group. In a December 2010 activity report to S&P management, Duka noted that S&P had lost a different CMBS new issue assignment due to criteria and again noted that “our criteria has historically been somewhat more conservative than the other agencies.”

Think of the evidence that Duka had. S&P required her to calculate a debt service coverage ratio that:

  • wasn't the actual debt service coverage ratio for the actual loans that she was rating, and
  • was more conservative than her competitors' calculations.

Maybe S&P's methodology was wrong? 

I guess it's too late to argue that now, though. Duka, says the SEC, tried to push through this change without going through S&P's Model Quality Review Group process. And the model quality reviewers, despite receiving information from Duka "which, although vague, was a red flag that the CMBS Group was no longer applying the 'higher of' methodology," never caught her. So everyone is in trouble -- Duka for trying to evade the internal controls, S&P for having controls that turned out to be easy to evade.

And both of them are in trouble for making ratings decisions based on a desire to win business, rather than on the disinterested search for truth in ratings. And the desire to win business is always a dangerous reason to change your ratings -- even if the change happens to be right.

  1. Actually it is "instituting a litigated administrative proceeding" against her, which is like suing but instead of taking her to court the SEC takes her to the SEC. It's weird.

  2. Though $1 million of penalties is for "failure to maintain and enforce internal controls regarding changes made to an assumption used in surveilling certain Residential Mortgage Backed Securities ("RMBS") supported primarily by seasoned (i.e., pre-2005) collateral with amortization periods of less than 30 years (i.e., short-amortizing collateral or loans)," and you can guess how boring that's gonna be. It is ... actually even more boring than I'd guessed? It is brutal stuff, but the gist of it is not too dissimilar to the "blended constant" stuff. Basically S&P had a generic number that it used to estimate loss severity for residential mortgages, and it realized that that number was not appropriate for a certain subset of mortgages, and so it started using a different, more optimistic number for those mortgages. And it didn't follow appropriate processes in making that change, so it got in trouble. But it self-reported the problem, and fixed it, and also the problem was dumb and procedural instead of substantive and evil, so the fine here was only $1 million.

  3. Actually that SEC order, in addition to criticizing the Great Depression stuff, has another complaint about S&P's 2012 ratings criteria that ... is not entirely clear to me. (Paragraphs 24-28 on page 6, if you're interested.)

  4. That's "disgorgement of $6.2 million, prejudgment interest of $800,000, and a civil money penalty of $35 million."

  5. Which strikes me as less straightforward than the denominator? Like, future cash flow depends on assumptions about occupancy rates and rents; it's not just specified in the terms of the loan, the way interest and amortization are. Particularly, S&P would calculate stressed coverage ratios "by beginning with the current net cash flow data provided by the issuers of the CF CMBS transaction and then applying stresses and discounts to estimate how the income from the property would be affected by economic circumstances." You'd think that estimating the stresses would be a good place to fudge numbers.

  6. Right? The underlying loans in the deals mentioned in the SEC orders all seem to be fixed-rate.

  7. The SEC draws a connection between the "criteria constants" and "stressed constants," a connection apparently sometimes made by S&P too. (See paragraph 12 here.) Here's a 2005 article saying that,

    Permanent loans are often sized not on the actual debt service constant (a rate that includes the actual interest rate and amortization), but rather on a "stress constant". A stress constant (sometimes referred to as a refinance constant), is a rate used by lenders (typically in the 8.0% to 11.0% range) to assure that, at the end of their loan term, they will be able to refinance out of their existing loan position. The assumption is that in a few years, interest rates will return to a more normalized level and the new lender will size the loan with appropriate coverages based on prevailing interest rates.

    It's not clear to me whether S&P intended its 2009 table of loan constants to reflect "stress constants" or "archetypal" real ones. I'm not sure it was clear to S&P either:

    After publication of the Criteria Article, extensive internal discussions ensued concerning the loan constants that S&P would use to calculate debt service. Some personnel took the position that S&P should use the published criteria constants while others argued that S&P should use “actual constants” derived from the terms of the loans. On or about July 31, 2009, senior S&P management affirmed that the firm would use the criteria constants to calculate DSCRs. On or about March 10, 2010, the CMBS criteria committee further decided that S&P would use the actual constants if higher than the criteria constants to determine debt service payments. Duka was the lead CMBS Group member on the CMBS criteria committee and signed the written decision of the CMBS criteria committee. The March decision was a minor change to the prior practice because actual loan constants were rarely higher than the criteria constants.

  8. I am not entirely sure why that's bad? Like, using the old methodology in the reports will get you a lower (worse) debt coverage ratio. So everyone buying the thing will say "hmm, this is rated AAA, but it has a debt service coverage ratio that looks worse than AAA, maybe I should stay away from it." It would be misleading to calculate ratios using the new method while claiming that you're using the old method -- but if you give people consistent ratios, and inconsistent ratings, how deceived are they? In fact they weren't:

    Several potential investors questioned the low level of CE for the AAA bonds in the GSMS 2011 GC-4 transaction. S&P gave a preliminary AAA rating to bonds with 14.5% CE. Using the DSCRs described in the Presale, which calculated DSCRs based on the criteria constants, S&P’s model would have required approximately 20% CE for the AAA bond.

    So the investors caught the discrepancy! Also this is good:

    Before publishing the Presales, Duka engaged in a conversation with her chief subordinate concerning whether to disclose anything about the relaxed criteria in the Presales. They decided to add the following sentence to a section in the middle of each Presale that described the conduit/fusion methodology: “[i]n determining a loan’s DSCR, Standard & Poor’s will consider both the loan’s actual debt constant and a stressed constant based on property type as further detailed in our conduit/fusion criteria.” This sentence did not inform investors that S&P had changed its methodology to use blended constants. It was instead consistent with S&P’s established methodology that considered both the actual constant and the criteria constant, and then chose the higher of the two. Duka’s subordinate, in sworn testimony, stated that the sentence was “written to be vague . . . based upon her instruction.”

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net