Standard and Poor’s (S&P) is being sued by the Department of Justice for providing fraudulent ratings on certain debt securities. Several of these securities received, S&P’s highest rating (AAA) in 2007, only to default in 20008. The Justice Department is alleging that S&P knew the debt was riskier than the rating they provided, however, gave out good ratings to make their paying clients happy.On first glance, the actions of the Justice Department would seem to be a positive for all investors. However, I believe that this lawsuit may negatively impact buyers of municipal bonds.
Why should the Department of Justice’s actions be positive for all investors?
The current business model for the credit rating agencies is inherently filled with a conflict of interest. Clients of the rating agencies (the people that pay them to rate a specific security) are the issuers and underwriters of the debt obligations. The clients want their debt obligations to receive the most favorable rating possible. Having a high rating enables a corporation or municipality to have lower borrowing costs on their bonds, and underwriters to sell the debt obligations at higher prices. As there are three major credit rating agencies and investors typically only need to see a rating from one, rating agencies don’t want to get a reputation for being overly critical in their ratings. As a result, there is a strong temptation not to provide an objective rating, but rather the rating that the client wants. The Justice Department is alleging, and I believe, that the rating agencies, specifically S&P, stopped being objective in certain cases.
S&P has given 3 arguments in their own defense. Here are my thoughts on them:
Everybody (Moody’s, Fitch) was providing similar ratings to S&P.
The fact that the entire industry was rotten does not excuse their actions. In fact, S&P claims that their analysis is completely independent of the other rating agencies. They should be defending their research and analysis process instead of trying to deflect blame.
We Told Clients Not To Exclusively Rely On Our Analysis
This is like Q-tips saying that you should not use their product to clear your ear. If you’re a dominant player in the rating space, investors do heavily rely and make decisions based on your analysis. Certainly, any piece of analysis can be based on flawed assumptions and come to inaccurate conclusions. However, they are not being charged with making mistakes. They are being charged with knowingly fudging their ratings.
The Market Was Changing Quickly & Hard To Analyze
To some degree, I think this is a valid excuse. Had home prices kept rising there would have been very few defaults. When real-estate prices have been rising for a 20 year period, how do you estimate the odds of them falling? However, there seems to be lots of inconsistency in their assumptions from one deal to another.
Bottom Line: I Think That S&P is Guilty & Their Management / Shareholders Should Be Punished
The Justice Department is asking for $5 billion in fines and penalties. While the final cost if the Justice Department prevails is expected to be far less, the cost will be significant for shareholders. The company’s stock (S&P is owned by McGraw Hill NYSE:MHP) dived from around $58 per share to $46, almost 30%, on the announcement by the Justice Department.
The immediate consequence of a drop in stock price and the long-term cost of a billion dollars + in litigation related expenses should have an impact on S&P’s oversight of its rating process. Furthermore, it should remind S&P’s competitors to make sure that their rating process is objective.
However, This Is Not Good News For Municipal Bond Investors
What doesn’t get mentioned frequently is that the rating problems did not involve municipal bonds. The problems that are being focused on in the Department of Justice’s case involve Collateralized Debt Obligations (CDO’s), which are complex products involving mortgages. For the most part, the rating agencies have a strong track record with municipal bonds.
There are several reasons why rating agencies do well rating municipal bonds:
- All the data that they use is publicly available. It is easy to see, if the assumptions that they are making with one municipality are being applied across the board.
- The assumptions that they make are based on years of data during both good times for municipalities and bad.
- With the exception of the largest municipalities which are rated by all three major credit rating agencies, no one municipality has the leverage to influence ratings.
After the credit crisis, the rating agencies changed or stopped rating 100s of CDOs. However, the number of rating changes for municipal bond issuers did not go through more than ordinary changes. (Please note, many bond issues had their rating cut because the companies that insured them had rating cuts.) In short, municipal bonds never had the problems of CDOs.
However, McGraw Hill as a company will be penalized, not just the division that rated CDOs. McGraw Hill will both be tempted to cut costs and be conservative with ratings. To lower costs, McGraw Hill might decrease rating staff. One way this could be done is to review municipal bond ratings less frequently, increasing the chance for major rating changes without warning. Additionally, McGraw Hill might want to appear that they are “tough” on ratings and tell their analysts to make very conservative assumptions. Changing the assumptions on municipal bonds would lead to giving ratings to municipal bond issues that are lower than they deserve.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.