by Jamey Dunn
McGraw-Hill, the parent company of the world’s largest credit rating agency, Standard and Poor’s, was slapped with lower bond ratings than the state of Illinois in February.
The downgrades, from Fitch Ratings and Moody’s Investor Services, came after the U.S. Department of Justice announced it is seeking $5 billion from S&P and McGraw-Hill as part of a civil suit against the company that rates the risks associated with investments. The department is accusing S&P of fraud in the way it handled risky mortgage-backed investment offerings before the country’s economic collapse in 2008. The bond rating agency, along with Fitch and Moody’s, gave high credit ratings to most of those investment options, which later went down in flames and took Wall Street along for the ride.
S&P downgraded Illinois’ rating in January after lawmakers failed to approve changes to the state’s pension system to address Illinois’ more than $96 billion unfunded pension liability. After the downgrade, Illinois has an A- rating from the agency, with a negative outlook. The state opted to delay a scheduled bond sale soon after the move for fear that the downgrade would lead to high interest rates. Fitch has kept the state at an A rating, but warned in January that it might see a downgrade in the near future.
Fitch bumped McGraw Hill down from an A- to a BBB+ rating, with a negative outlook, a fate Illinois could easily share in the near future. Moody’s took the company down two notches from an A3 to a Baa2 rating. The agencies downgraded the well-known textbook publisher, which also owns the S&P and Dow Jones market indices, over the potential blow to the company’s profits and reputation as a barometer in the financial industry if it loses its legal battle with the Justice Department.
The department has accused S&P of deliberately misleading investors about the risks involved with various complicated investment products linked to mortgages. Those products were often tied to unstable subprime mortgages with balloon payments and predicated on borrowers meeting their obligations. The civil complaint says that the firm ignored warnings and put off implementing new analysis models that would have likely resulted in lower ratings of the investments.
“This alleged conduct is egregious, and it goes to the very heart of the recent financial crisis,” U.S. Attorney General Eric Holder said when he announced the lawsuit at a Washington, D.C., news conference. Holder says that by 2003, analysts in the company had started to raise concerns about the way S&P was rating mortgage-backed investments. “S&P executives allegedly ignored these warnings and between 2004 and 2007 concealed facts, made false representations to investors and to financial institutions and took other steps to manipulate criteria and credit models to increase revenue and market share,” Holder said.
Fifteen state attorneys general have joined the suit, including Illinois Attorney General Lisa Madigan. Madigan has her own suit against S&P. “Over a year ago, I filed a lawsuit in Illinois against S&P for fraudulently assigning its highest ratings to risky mortgage-backed investments that enabled the destruction of our nation’s economy and resulted in the loss of millions of Americans’ jobs, homes and financial security,” Madigan said in Washington, D.C.
The Justice Department and Madigan attribute S&P’s alleged behavior to a conflict of interest inherent in its business model. When bond raters started out in the early 1900s, investors paid them for reliable information about potential investments. But in the 1960s and 1970s, the two major rating agencies, S&P and Moody’s, began charging bond issuers for ratings instead of selling information to investors. Multiple factors led to the change, but perhaps the biggest motivator was new technologies, such as copy machines, that allowed investors to share analyses with others who did not pay for them.
The Justice Department’s complaint cites several employee communications that appear to indicate that S&P was overlooking problems with rating models for fear of clients leaving to seek more favorable ratings from competitors Moody’s and Fitch. One instant message exchange between S&P analysts:
Analyst 1: “[By the way] that deal is ridiculous.”
Analyst 2: “I know right … model [definitely] does not capture half of the … risk.”
Analyst 1: “We should not be rating it.”
Analyst 2: “We rate every deal. … It could be structured by cows, and we would rate it.”
Another employee circulated an email in 2006 that voiced fears about the housing market and the investments based on it in the form of a parody song set the tune of the Talking Heads’ hit “Burning Down the House.” He sent a follow-up email that read: “For obvious professional reasons, please do not forward this song. If you are interested, I can sing it in your cube.”
The Financial Crisis Inquiry Commission asked Gary Witt, a former team managing director at Moody’s, if he ever felt pressured by investment banks concerning ratings. “Oh, God, are you kidding? All the time. I mean, that’s routine. I mean, they would threaten you all of the time. … It’s like, ‘Well, next time, we’re just going to go with Fitch and S&P.’” Congress created the commission to investigate the causes of the economic collapse.
According to the Justice Department, mortgage-backed investments rated by S&P just in the months of March through October 2007 were responsible for more than $5 billion in losses. Almost every one of a specific type of security based on underlying mortgages, known as a collateralized debt obligation, that was rated by the firm during that period later failed.
But S&P wasn’t alone in these misguided ratings. According to the Financial Crisis Inquiry Commission’s report, Moody’s gave nearly 45,000 mortgage-related securities AAA ratings between 2000 and 2007. In 2006, Moody’s gave its top credit score to 30 such investments on every business day. More than 80 percent of those were eventually downgraded. The report also criticizes Fitch, the smallest of the three major credit rating firms, for its ratings during the lead-up to the collapse.
“The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar, and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”
Some opinion makers in the financial sector see retribution in the department’s singling out S&P because it was the only agency to downgrade the U.S. credit rating. Others speculate that the department may be in settlement talks with Fitch and Moody’s. Holder has denied that the S&P suit has any connection to the firm’s 2011 downgrade of the country’s credit. S&P was in settlement talks with the Justice Department, but according to the New York Times, the company opted to take its chances in court rather than take the deal the feds were offering. The paper reported that the department was seeking a $1 billion penalty and an admission of fraud. Such an admission could open up S&P to lawsuits from clients and investors.
A spokesperson for Madigan said she has not ruled out suits against the other rating agencies. “These new lawsuits demonstrate an expanding state and national effort to hold S&P accountable for the central role they played in the subprime mortgage market’s collapse,” Madigan said of the Justice Department’s actions. “Quite frankly, S&P was a trigger for the destruction of our economy. While big banks and lenders built mortgage-backed bombs, it was S&P’s faulty rating that detonated them.”
Pretty harsh words, considering that the same bond rating agency is helping to frame the agenda in the General Assembly. Gov. Pat Quinn and lawmakers on both sides of the aisle constantly cite the fear of bond-rating downgrades as one of the primary reasons for urgency when it comes to addressing the state’s pension problems. And there is little way around it. The state needs to sell bonds to continue capital construction projects, and it cannot do that without bond ratings. The lower the ratings, the more the state pays in interest on those sales.
Pension proposals, such as one from Ralph Martire, executive director of the Center for Tax and Budget Accountability, are not even on the table because of fears that they would likely do little to appease the rating agencies. Martire suggests that the state change the way it pays down the pension liability. “Given that the current repayment schedule is a complete legal fiction — a creature of statute that doesn’t have any actuarial basis — making this change is relatively easy. Simply re-amortizing $85 billion of the unfunded liability into flat, annual debt payments of around $6.9 billion each through 2057 does the trick. After inflation, this new, flat, annual payment structure creates a financial obligation for the state that decreases in real terms over time, in place of the dramatically increasing structure under current law. Moreover, because some principal would be front- rather than back-loaded, this re-amortization would cost taxpayers $35 billion less than current law,” Martire wrote in an opinion piece for Crain’s Chicago Business.
And proposals to borrow billions to pay down the state’s backlog are barely on the political radar, in part because of concerns about how such borrowing would play with the rating agencies.
Each of those plans has a downside. Martire’s proposal would increase upfront pension costs while the state continues to experience a budget crunch, and Illinois has one of the higher per capita debt loads in the nation. It is not certain whether either idea would work. But it is frustrating that institutions whose actions — either fraudulent, inept or both — contributed to the U.S. financial collapse now hold such sway over the policy debate in our state as it struggles to recover.
Illinois Issues, March 2013