Can we now admit it’s time to end issuer-pays credit rating model?
In July 2007, a recently hired analyst in Standard & Poor’s structured finance group exchanged a series of emails with an investment banking client who wanted to know how the new job was going. Things were just great, the analyst said sardonically, “aside from the fact that the MBS world is crashing, investors and media hate us and we’re all running around to save face … no complaints.” Part of the problem, the analyst said in a subsequent email, was that some people at S&P had been pushing to downgrade structured finance deals, “but the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.
I suspect that only an investment banker could find it in his or her heart to sympathize with a credit analyst in the summer of 2007, but this one suggested that some good might come from S&P’s internal conflict. “This might shake out a completely different way of doing biz in the industry,” the banker wrote. “I mean come on, we pay you to rate our deals and the better the rating the more money we make?!?! Whats up with that? How are you possibly supposed to be impartial????”
The email exchange, recounted deep in the Justice Department’s new civil complaint against S&P and its parent, McGraw-Hill, pretty well sums up the entire theory of the government’s case against the rating agency. S&P, according to the Justice Department, had a choice as the housing market began to collapse and subprime mortgages began to default. Rating agency analysts who monitored mortgage-backed securities knew the crash was coming and warned repeatedly that previous ratings of mortgage-backed instruments were no longer a reliable gauge. But rather than heed those warnings and toughen standards on mortgage-tied instruments, S&P continued to accept fees from banks in exchange for conferring its blessing on tens of billions of dollars of collateralized debt obligations. When truth collided with the client relationships that generated S&P’s revenue, in other words, money won out.
That essential accusation against the credit rating agencies is not new. Congress, the private plaintiffs’ barand some state attorneys general have been claiming for years that S&P and its fellow rating agencies, Moody’s and Fitch, were more concerned about their share of the lucrative market for rating structured finance products than with the reality of their ratings. The Justice Department’s complaint, filed in federal court in Los Angeles and seeking damages under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, does add some juicy new details to what’s already been alleged about S&P. As far back as 2004, according to the complaint, S&P was sculpting its analytics to satisfy the banks that paid it to rate their products. When one S&P executive, for instance, asked why a proposed new system for evaluating mortgage-backed securities was shelved even though it generated more accurate ratings than the old model, he was supposedly told that if the new system “was not going to result in S&P increasing its market share or gaining more revenue, there was no reason to spend money putting it in place.”
On the other side of the subprime bubble, as defaults began piling up in the spring of 2007, S&P analysts tracked the deteriorating performance of mortgage-backed securities rated by the agency. (One creative fellow, according to the Justice Department complaint, even devised a dance video on the impending crash, based on “Burning Down the House” by Talking Heads.) An internal S&P report in June 2007 disclosed that the lower tranches of the 18,000 subprime mortgage-backed securities rated by the agency were experiencing double the delinquencies anticipated in the agency’s precrash model. High-level S&P executives who oversaw CDO ratings were warned that losses in 2006-vintage mortgage-backed securities could top 25 percent. Yet officials in the CDO rating division did not pass that information from MBS analysts along to line-level CDO analysts. In June 2007 alone, S&P rated at least 12 CDOs priced at more than $27 billion.
And why not? As the complaint explains with cold, hard numbers, S&P was making good money by disregarding its analysts’ doomsday predictions. Under the issuer-pays model for credit ratings, S&P and its fellow rating agencies earn fees when they deliver the ratings issuers want. Issuers, in turn, willingly chip up those fees because they need AA or AAA ratings to sell their complex instruments to investors like state and union pension funds and credit unions, which are frequently restricted from buying anything but high-rated securities. That symbiosis worked well for the credit agencies in the subprime bubble, as long as they supplied high ratings. According to the complaint, S&P charged issuers between $500,000 and $750,000 for each CDO it rated, provided that the rating process was completed and the deal went through. If the issuer withdrew its ratings request (because, for example, the proposed rating was too low or another rating agency offered a less stringent evaluation model), S&P would collect “only a fraction of the rating fee it would otherwise earn,” the complaint said. In 2006 and 2007, even as the crash loomed, S&P’s Global CDO unit supposedly generated $385 million. The Global Asset-Backed Securities Unit – which was supposedly rating MBS at such a fast clip that S&P rating committees spent less than 15 minutes reviewing analyst evaluations – kicked in another $278 million in revenue in 2006 and $243 million in 2007.
Who loses in the issuer-pays model? You know the answer: all those investors who kept buying mortgage-referenced CDOs in 2007 because they didn’t see the surveillance reports S&P’s analysts prepared on delinquencies in S&P-rated mortgage-backed securities. Sure, some CDO and MBS buyers were just as savvy as issuers about the dreck dressed up with AAA ratings. But plenty were not. They relied on credit rating agencies to live up to their promise of independence and objectivity. And look where that got them.
The Justice Department complaint against S&P dispels one of the only justifications for the issuer-pays system of rating securities. Supporters of the model contend that it saves investors the cost of evaluating securities themselves. But according to the complaint, issuers typically passed on to investors the rating fees they paid to S&P. Such costs were considered part of the “organizational and structuring fees and expenses,” which came out of the proceeds of CDO and MBS sales, according to the Justice Department. So investors were doubly deceived, not only duped by misleading ratings but also hit for the cost of their own victimization.
We obviously don’t know whether the Justice Department will ultimately collect anything from S&P, let alone the more than $1 billion it wants, according to The New York Times. S&P has strongly denied the government’s allegations and argues that it has already spent $400 million to “reinforce the integrity, independence and performance” of its ratings. S&P’s lead lawyer, Floyd Abrams of Cahill Gordon & Reindel, hinted to CNBC that the government’s suit is retribution for S&P’s downgrade of the U.S. credit rating in 2011.
But based on the allegations in the complaint, we can certainly say that the issuer-pays model doesn’t work. Fallout from the financial crisis has shown time and again that when money is at stake, investors cannot rely on systems contingent upon the honor of financial institutions.
Congress knows the danger of issuer-pays credit ratings. In the Dodd-Frank Act, it instructed the Securities and Exchange Commission, which has regulated the credit rating agencies since 2007, to conduct a study on the model and issue a report on its findings. The SEC report came out in December but didn’t get much notice because the agency took more than 80 pages to come to no conclusions. My friend Susan Beck at the Am Law Litigation Daily called the SEC report a “maddeningly meek 82-page document (that) reads like a memo written by a summer associate hopped up on Red Bull. There’s a lot of stuff in it, but not a single clear, original thought.”
The SEC, or Congress, can do better. There are alternatives to the issuer-pays model. (The SEC report gives them a thorough airing, even though it studiously avoids reaching any conclusions.) Investors could directly share with issuers the cost of rating securities, or could fund their own independent credit rating agency. Or perhaps the government or an independent board could administer credit ratings, either by allocating assignments on the basis of market share or by overseeing auctions in which rating agencies compete for business. The point of all the alternative models is to recalibrate the incentives of rating agencies so their revenue doesn’t depend on delivering the results issuers want.
As the investment banker told the S&P analyst back in 2007, it’s time for a completely different way of doing biz in the industry.
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