February 5, 2013
S&P Complaint, Bombshell upon Bombshell!
DoJ’s complaint is chock full of interesting allegations. Previous critiques of the rating agencies rehashed a handful of embarrassing emails that made their way into an SEC staff report a few years ago (“It could be structured by cows and we would rate it.”). The complaint has a lot more substantive allegations of conflicts of interest that are rampant in the rating agency industry.
The complaint states that, “In carrying our the scheme to defraud, S&P falsely represented that its credit ratings of RMBS and CDO tranches were objecivie, independent, uninfluenced by any conflicts of interest that might compromise S&P’s analytic judgment, and reflected S&P’s true current opinion regarding the credit risks the rated RMBS and CDO tranches posed to investors.” (2)
Some highlights from the allegations contained in the complaint:
- From an S&P strategic plan: “The primary customers of the CDO group today are the deal arrangers (bankers/intermediaries). This customer group continues to be responsible for the bast majority of revenue, including all initial deal rating fees paid to S&P.” (16, emphasis in the original)
- In response to a new rating process that “required consideration of ‘market insight’ and rating implications and the polling of both ‘3 to 5 investors in the product’ and ‘an appropriate number of issuers and investment bankers for a full 360-market perspective,” an S&P executive wrote,
What do you mean by “market insight” with regard to a proposed criteria change? What does “rating implication” have to do with the search for truth? Are you implying that we might actually reject or stifle “superior analytics” for market considerations.? Inquiring minds need to know. (40)
- With echoes of Quattrone’s suggestion to follow his firm’s document retention policy, S&P executives prepared a memorandum that stated that “concerns with the objectivity, integrity, or validity” or rating criteria should not be put in writing unless it was addressed to an S&P attorney which would presumably trigger attorney-client privilege. (41)
- An S&P analyst wrote, “We just lost a huge Mizuho RMBS deal to Moody’s due to a huge difference in the required credit support level.” The analyst continued, “What we found from the arranger was that our support level was at least 10% higher than Moody’s.” The analyst continued, “Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact on future deals. There is no way we can get back on this one but we need to address this now in preparation for the future deals.” (44-45)
- Another analyst wrote, “Remember the dream of being able to defend the model with sound empirical research? The sort of activity a true quant CoE [the analysts job at the time] should be doing perhaps? If we are just going to make it up in order to rate deals, then quants are of precious little value. I still believe that people want the model to be consistent with history, and that the impact of the model will not destroy the business.” (51)
- An S&P PowerPoint presentation stated that to come up with Probabilities of Default (PDs) in certain contexts, “we look at our raw data and come up with a statistical best fit. When this does not meet our business needs, we have to change our parameters ex-post to accommodate.” The slide continued, “Does this work [for] our rating business? If it does not, need to tweak PDs.” (56)
S&P is going to have a tough time harmonizing those statements with the numerous assertions of their objectivity, such as those found in its Code of Practices and Procedures:
- S&P’s “mission has always remained the same — to provide high-quality, objective, independent, and rigorous analytical information to the marketplace” (28)
- “Ratings assigned by Ratings Services shall not be affected by an existing or a potential business relationship between Rating Services (or any Non-Ratings Business) and the issuer or any other party, or the non-existence of such relationship.” (29)