Ratings companies, whose scores have helped determine the costof money for governments and businesses for more than a century,are no longer trusted by the world's biggest investors, accordingto the former head of structured finance at Standard &Poor's.

“They're there because people have to have them, not becausepeople believe in them,” David Jacob, who was fired from S&P inDecember, said in an interview at Bloomberg headquarters in NewYork. “Maybe retail investors do, that's the unfortunate part, butI think institutional investors don't.”

After helping ignite the worst financial crisis since the GreatDepression by inflating grades on securities backed by subprimemortgages, the ratings firms' reputations are being diminishedfurther in the bond market. When S&P downgraded the U.S.government in August, Treasury yields fell to record lows, and thecost of protecting financial debt declined following last month'sdowngrades of 15 global investment banks by Moody's InvestorsService.

Jacob, hired four years ago to help restore confidence inS&P, says policy makers haven't gone far enough to reducereliance on the ratings companies, granted the authority by U.S.regulators 76 years ago to determine which borrowers deservecredit.

The ratings business is now dominated by S&P, a NewYork-based unit of McGraw-Hill Cos., Moody's and Fitch Ratings. Thethree produce a combined $4 billion in annual revenue with 3,600analysts ranking 2.73 million securities worldwide in the $43trillion global bond market.

“Ratings are not God's holy work,” said Jacob, 56, a graduate ofQueens College in New York with degrees in math and finance fromNew York University. “It's a business. It's a fine balance betweentrying to get a certain amount of market share versus losing yourcredibility.”

Bond investors respond faster than ratings firms to shifts inrisk, Ken Fisher, chief executive officer and founder of Woodside,California-based Fisher Investments, said in a telephone interviewafter Moody's downgraded Morgan Stanley, UBS AG and 13 other globalbanks on June 21.

“Moody's is not going to detect some problem in advance and movea rating to warn the public,” said Fisher, whose firm manages about$44 billion. “Whether it's a stock or a bond, the free marketalready did that. Moody's goes along afterwards and effectivelyvalidates what the market's already done.”

Spokesmen for S&P, Moody's and Fitch declined to respond toJacob's remarks.

'Strict Standards'

S&P President Douglas Peterson said at a meeting of theInstitute of International Finance in Copenhagen on June 6 thatratings companies help ensure that bond issuers provide“transparent information” under “strict standards of governance andcontrol.”

During the housing boom, analysts at the three firms werepressured to give their stamp of approval to complex investments towin lucrative business from Wall Street banks, the Senate PermanentSubcommittee on Investigations said last year in a report.

With the cooperation of the ratings companies, bankers spunrisky mortgages into securities supposedly as safe as governmentbonds, allowing risky lending to accelerate.

In 2007, the year before Jacob took over, S&P's structuredfinance group took in $561 million in revenue, sometimes chargingbanks more than $1 million to rate a single offering, according tothe Senate panel. About 90 percent of AAA securities backed bysubprime mortgages from 2006 and 2007 were later cut to junk, orbelow Baa3 by Moody's and lower than BBB- at S&P.

The credit crisis that followed still weighs on economic growthworldwide. Home prices in the U.S. are off 34 percent from theirpeak in July 2006, according to the S&P/Case-Shiller index.Governments were forced to bail out banks that faced $1.5 trillionin write-downs and losses.

Jacob joined S&P after managing commercial- andresidential-mortgage bond groups at Nomura Holdings Inc. from 1993to 2007. He said he sought to ensure that S&P analysts didn'tloosen standards at the request of bankers. The firm won lessbusiness in certain areas as a result.

“We've swung back from where it was before when it felt morelike the Wild West, but of course it puts a crimp on the business,”Jacob said in the interview last month. “It's important forinvestors to watch to see if there's a change and a shift in termsof trying to rebuild that market share.”

'Tighten Up'

Jacob may be criticizing the firm because of his dismissal,Peter Appert, an analyst at Piper Jaffray & Co. in SanFrancisco, said in a telephone interview.

Peterson has been bringing in new executives after a series ofmiscues at S&P, including a bungled commercial-mortgage dealand its handling of the U.S. downgrade, said Appert, who doesn'tknow Jacob or his particular circumstances.

Peterson demoted Mark Adelson from chief credit officer to aresearch role last year, and Barbara Duka, head ofcommercial-mortgage ratings, was replaced.

“Peterson was brought in to try to address some of these issuesand tighten up operations,” said Appert, who has the equivalent of“buy” ratings on McGraw-Hill and Moody's stock.

S&P cut the credit grade of the U.S. one step to AA+ inAugust, criticizing lawmakers for failing to cut spending or raiserevenue enough to reduce record budget deficits. After the TreasuryDepartment said S&P made a $2 trillion error in itscalculations, the ratings company switched the budget projectionsit was using and proceeded with the downgrade. S&P denied itmade a mistake and said using the government's preferred fiscalscenario didn't affect the credit rating.

Following the downgrade, yields on 10-year Treasuries fell to aslow as 1.45 percent in June from almost 3 percent last August,indicating investors view the U.S. as more creditworthy, not less.Almost half the time, yields on government bonds fall when a ratingaction by S&P and Moody's suggests they should climb, accordingto data compiled by Bloomberg on 314 upgrades, downgrades andoutlook changes going back as far as the 1970s.

Grading government bonds is outside ratings companies'traditional areas of expertise, Jacob said.

“You're talking about politicians, you're talking aboutlegislators, you're not talking about credit risk,” he said. “Idon't see how a rating agency has any better call on it than you orme or anybody else.”

Moody's, which helped start the business of ranking companies bytheir ability to repay debt in 1909, cited “the volatility and riskof outsized losses inherent to capital-markets activities” for itsbank downgrades, according to a June 21 statement.

Bank Rally

While Moody's now has the banks rated an average four levelslower than at the height of the financial crisis, investors see thelenders as more creditworthy. Yields on their bonds fell to anaverage 3.77 percent as of yesterday from 8.46 percent in October2008, Bank of America Merrill Lynch index data show.

The cost of protecting the banks' debt from default fell as muchas 26 basis points after the downgrades, Bloomberg data show. As ofyesterday, the average was down 1 basis point to 245, meaning itcosts $245,000 a year to insure against losses on $10 million oftheir bonds.

In response to the ratings companies' role in the creditseizure, the U.S. passed the Dodd-Frank overhaul of financialregulation in 2010, instructing regulators to remove references toratings in the rules that determine everything from bank capital tomoney-market fund holdings.

In Europe, lawmakers are debating new rules that would forcebanks to rotate which companies they hire to grade certainsecurities and restrict when sovereign ratings could bereleased.

The ratings companies' grades have carried extra weight sincethe Office of the Comptroller of the Currency banned banks fromholding bonds that were below investment grade in 1936.

“We have a longstanding integration of ratings into financialregulation,” Larry White, a professor at New York University'sStern School of Business who's testified before Congress aboutcredit ratings, said in a telephone interview. “That hasunnecessarily enhanced the importance of the big three ratingfirms.”

Moody's and S&P have become a “natural duopoly,” able tosell their services even to those who don't like them, WarrenBuffett, the chairman of Berkshire Hathaway Inc., told theFinancial Crisis Inquiry Commission in 2010. Berkshire is an“unwilling customer” of Moody's when it issues bonds, Buffettsaid.

'Necessary Evil'

That hasn't stopped the world's third-wealthiest man fromappreciating the profit opportunities. Berkshire is Moody's biggestshareholder with a 13 percent stake valued at about $1 billion.

Institutional investors and their clients use ratings to setguidelines that determine which bonds can be held in theirportfolios, even if they don't rely on the companies for investmentadvice, according to Bonnie Baha, head of global developed creditat DoubleLine Capital LP, which oversees $35 billion.

“You have to have some sort of a credible, third-party way tobenchmark those categories,” Baha said in a telephone interviewfrom Los Angeles. “The rating agencies are sort of a necessary eviluntil a better alternative comes along.”

As head of S&P's structured-finance business, Jacob oversawthe department that rated commercial-mortgage bonds, which aresecurities composed of loans for office buildings, hotels andshopping centers.

Wall Street has been freezing S&P out from that market sincelast July, when it withdrew its ratings on a $1.5 billion deal andforced Goldman Sachs Group Inc. and Citigroup Inc. to scuttle theoffering after it was sold to investors.

S&P took too long to investigate a possible error that ledit to pull its grades, Jacob said. Had S&P acted more quicklyon the discrepancy, which turned out not to affect the bonds'ratings, the deal could have been postponed rather than canceled,he said.

“My frustration was how long it takes to correct it and tofigure it out,” Jacob said. Telling investors and bankers that theratings would be pulled “was probably the most embarrassing anddifficult conversation I've ever had,” he said.

On Dec. 8, about three months after Peterson took over aspresident for Deven Sharma, S&P said Jacob would be leaving thecompany at the end of the year. After thanking Jacob in astatement, Peterson said that Paul Coughlin would take over thestructured-finance business temporarily while he reorganizedmanagement along regional lines.

“I thought my work wasn't finished,” Jacob said. He said he'snot sure why he was replaced.

Jacob said he is now considering working in financialregulation. One reform that would improve the quality of ratingswould be to have all scores correspond to percentage chances ofdefault, rather than the vague definitions now in use. S&P saysits top rating means the issuer is “extremely strong,” while Aaabonds are considered “highest quality” at Moody's.

“I was there three and a half years and I still don't understandit,” Jacob said. “When people can use the same set of letters andmean entirely different things, then they become useless.”

Bloomberg News

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