The U.S. Securities and Exchange Commission’s potential suspension of Standard & Poor’s from grading commercial-mortgage backed bonds would threaten a practice regulators have blamed for fueling the credit crisis.
The SEC has been investigating whether the firm bent ratings criteria to win business in 2011, according to a person with knowledge of the matter, who asked not to be named because discussions between the agency and S&P about a possible suspension are private. In a practice known as ratings shopping, banks often seek assessments from several credit graders and choose the ones that give the most favorable views when assembling asset-backed bond deals linked to everything from auto loans to mortgages.
“Even temporarily taking away a slice of S&P’s business would send a powerful message to the rest of the market that the SEC is serious about attempting to address ratings shopping,” said Jeffrey Manns, an associate professor of law at George Washington University in Washington.
A suspension would be the SEC’s toughest punishment yet against one of the three-biggest credit raters, which have been blamed for fueling the 2008 financial crisis by giving top ratings to securities that later soured. S&P’s parent, New York- based McGraw Hill Financial Inc., disclosed in July that SEC investigators were pursuing an enforcement action tied to CMBS deals it rated in 2011.
Catherine Mathis, a spokeswoman for McGraw Hill, declined to comment, as did John Nester, a spokesman for the SEC.
“As we stated in our third-quarter earnings, we’re in active discussions with the SEC to resolve matters that are pending there,” Chief Executive Officer Douglas Peterson said at an investor conference yesterday.
The deal that triggered the turmoil at S&P began with controversy. S&P stamped AAA ratings on parts of a deal that offered investors less of a cushion against losses than the ratings firm had allowed on similar transactions. That raised concern that S&P was caving in to issuers to win business and leading bond buyers to question the ratings company’s methodology. Analysts led by Barbara Duka, who was the head of the CMBS group at the time, held a conference call to field questions from investors on how they were assessing risks of the deal.
Goldman Sachs Group Inc. and Citigroup Inc. subsequently rejiggered the transaction to boost investor protections, increasing the buffer that protected AAA securities from loan defaults by adding to the amount of lower-ranked debt that was first to absorb losses. The banks then placed the deal with investors, only to pull it a week later when S&P withdrew its rating, citing a discrepancy in its models.
The next month, S&P said the conflict wasn’t significant and it would resume grading the sector. The rater didn’t win any CMBS business for more than a year, then revised its ratings criteria in 2012 before re-entering the market.
Since the pulled deal, S&P has primarily rated single- borrower transactions, in part because it uses a methodology allowing for a more optimistic outlook on a building’s future value than that employed by Moody’s Investors Service, according to bankers that arrange CMBS deals. That opinion allows lenders to build smaller investor cushions and increase their profits.
Without S&P, which has graded 75 percent of single-borrower deals in 2014, issuance of the securities may decline next year since Moody’s and Fitch Ratings require higher credit enhancement levels, according to a Dec. 9 Nomura Holdings Inc. report.
When raters establish tougher criteria, banks can find other options. Wall Street started dropping Moody’s CMBS grades last year after the company demanded greater investor protections to balance increasingly risky loans.
Ratings shopping has become systematic in 2014 as lending guidelines loosen further, leaving investors more exposed to borrower defaults and making new offerings appear safer than they really are, according to Credit Suisse Group AG.
“Most default and loss models are underestimating the ultimate losses on these deals,” the analysts led by Roger Lehman said in a Nov. 21 report.
During the housing bubble that began to burst in 2006, ratings shopping fueled a “race to the bottom” among the companies to avoid losing market share, the U.S. Senate’s Permanent Subcommittee on Investigations said in a 2011 report.
The credit-grading business was then targeted by lawmakers in the 2010 Dodd-Frank Act to examine whether its business models needed to be changed. The SEC decided to keep the model in place in August, opting instead to increase internal controls and boost disclosures.