The recent charges being leveled against Standard & Poor’s ratings criteria for commercial-mortgage backed securities brings to mind memories of the false comforts during the latest housing boom.
That’s right, those cozy moments in 2005 when bond investors thought everything was going great — after all, they had these triple-A ratings telling them so.
We know how that story ended, or rather unfolded, as we still feel the sting of those poor decisions made by the credit ratings agency, even today.
Bloomberg got the scoop and set the story off and running:
“The U.S. Securities and Exchange Commission will suspend S&P from rating securities in the biggest piece of the commercial-mortgage bond market, according to a person with knowledge of the matter. McGraw Hill Financial Inc., S&P’s parent company, will pay $60 million as part of the SEC deal and is also expected to reach settlements with the attorneys general of New York and Massachusetts, said the person and another familiar with the matter.”
And so enters the Securities and Exchange Commission with this gem:
“SEC announces charges against Standard & Poor’s for fraudulent ratings misconduct.”
Ladies and gentlemen, it’s been some time since the mortgage bond world felt shaken to the core. But shaken, right now, it feels, according to several recent conversations I’ve had on the subject.
“They lied,” one source told me about the SEC charge that S&P “published a false and misleading article purporting to show that its new credit enhancement levels [for CMBS ratings] could withstand Great Depression-era levels of economic stress.”
As a result, the SEC banned S&P from rating similar deals for a year. S&P agreed to pay more than $58 million to settle the SEC’s charges, plus additional fines to three attorneys general. The fines cover the false ratings of six conduit fusion CMBS transactions in 2011.
“The question remains, did they also do this for residential mortgage bonds?” the source asked.
The answer, sadly, is probably yes.
And, these residential mortgage bond deals fit squarely in the bailiwick of HousingWire:
“A third SEC order issued in this case involved internal controls failures in S&P’s surveillance of residential mortgage-backed securities ratings. The order finds that S&P allowed breakdowns in the way it conducted ratings surveillance of previously-rated RMBS from October 2012 to June 2014.
“S&P changed an important assumption in a way that made S&P’s ratings less conservative, and was inconsistent with the specific assumptions set forth in S&P’s published criteria describing its ratings methodology.
“S&P did not follow its internal policies for making changes to its surveillance criteria and instead applied ad hoc workarounds that were not fully disclosed to investors.”
S&P claims the inaccurate descriptions are being corrected and publicly retracted the false and misleading information.
S&P neither admits nor denies the claims, of course, and for once I think that is a bad call.
My reporters covered these deals, and also trusted in S&P’s ratings criteria. It may be awhile before that trust gets restored.
So what’s the impact on the market? It’s good and bad.
This is from a Barclays note to clients:
“In the conduit space, S&P only rated 5.6% of the market in 2014, and all of these bonds were also rated by either Fitch or Moody’s. With the small market share, the new issue market is likely to be unaffected by the loss of S&P in 2015.”
Whew. The impact on the market is thankfully muted.
Wait. The bonds were also rated by Fitch and Moody’s. If those two credit ratings agencies also awarded the bonds similar ratings, then what does that say about the ratings criteria of all Nationally Recognized Statistical Rating Organizations?
Presumably, the ratings were similar and did not raise any alarm bells. It wasn’t until the author of the S&P CMBS report complained to the SEC that the work was being used as a “sales pitch” to drum up more CMBS business for S&P that anyone stopped to take note.
That’s what is completely and utterly shocking about this announcement.
This news highlights that we must continue to take ratings for what they are: a supplemental risk-measurement tool — not a replacement for internal investor due diligence.
But, lo and behold, the S&P charges unveil an even more disturbing truism; there is no real regulatory authority to reach over the credit ratings agencies.
CRAs remain vital to the capital markets component of financial services, yet Dodd-Frank fails to address these firms.
In fact, CRAs are specifically omitted in this financial overhaul.
Some overhaul.
HousingWire senior financial reporter Trey Garrison spoke exclusively with co-author Barney Frank about this seemingly suspicious approach to financial regulations. It calls to mind the scene in The Wolf of Wall Street, where the FBI agent onboard Jordan Belfort’s yacht mentions that the SEC is merely a civil authority.
Credit ratings agencies have yet to raise the ire of anyone else. Now, I’m not suggesting that anything criminal is happening here, but it is odd that 1,000+ pages of financial law, which created a massive consumer protection bureau, does so little to protect against services investors pay for. Are they not consumers here as well?
Here’s Frank’s defense:
“We thought it was best to remove from statute books any regulations and requirement that an investor rely on ratings agencies. The best thing in my mind is for people to do their own due diligence.
“But if you want to (rely on ratings agencies), great, but it took away any federal imprimatur. They went for the standard of recklessness and not negligence that I would have wanted.”
People do their own due diligence? So why do we need credit ratings agencies in the first place?
Investors want to read, maybe, four pages of due diligence on any particular product — what they win or lose in the investment is on them.
But what if that document, which the issuer paid to have delivered to them, is found to be later misleading? Is a financial penalty enough?
Again, I’m not suggesting anything criminal is happening here, because simply put, I don’t have to.
This S&P settlement also put everyday consumers and business owners up in arms, judging by reader comments on HousingWire.com.
“Where are the criminal charges? It is tiresome that we see fines levied for crimes, but those responsible remain untouched,” said reader Rick Neff.
“I am one of the principals of an independent title agency in western Pennsylvania. All of my employees undergo regular criminal background and credit checks. We do regular fraud training to protect the consumer. There are good companies and good people in real estate. Greed needs to be shown the door.
“You can be successful while being consumer oriented,” Neff wrote.
Prolific commenter Sandy Jean responded that the S&P development “Doesn’t surprise me. Is there anywhere in housing industry that doesn’t commit fraud? Reporting organizations such as HousingWire will be kept busy for a long time as more fraud is discovered.”
And in response to Neff’s response she added: “Too bad so many are not as scrupulous and vigilant as you are. You can be successful and honest at the same time.”
So don’t think of these settlements as not touching consumers. The digital age means word gets around and these misdeeds should be admitted (didn’t happen), reprimanded (happened), and reinvestigated internally (not going to happen).
The reason that the latter is not going to happen is because it represents an, as yet, unnecessary cost to S&P. There is no motivation for the CRA to investigate deeper into their inner working to see if similar fraud took place in other asset classes.
There may be more instances, there may not be. But right now, we’ll never know.
Especially if “financial reform” neglects to reform certain areas of the finance industry.
