Journalism in the Public Interest

Years After Tobacco Deals Sold, SEC Says Rating Agencies Still Conflicted

The latest Securities and Exchange Commission examination of credit rating firms found problems similar to those documented in ProPublica’s investigation of tobacco bonds.

(David Sleight/ProPublica)

In our story last month about credit rating agencies and tobacco bonds, we detailed numerous instances in which bankers pressured Standard & Poor's, Fitch and Moody's to give favorable treatment to bond issues being put together on behalf of state and local governments.

Documents showed that the bankers brazenly played one firm against another to relax rating criteria and grade risker, longer-term tobacco bonds. These actions mostly pre-dated the 2008 financial crisis, in which the raters earned widespread criticism for giving high marks to bum mortgage securities packaged by Wall Street.

Now, a new report from the rating agencies' regulator, the Securities and Exchange Commission, found similar conflicts of interest at the firms, which are supposed to evaluate the riskiness of various debts at arm's length from the banks and issuers they serve.

The SEC's annual examination of the firms' business practices, published on the same day as ProPublica's ratings story, cited numerous examples of how the firms continued to compromise the objectivity of their rating process during the 2013 calendar year. For instance:

  • One of the top three rating firms changed its rating criteria "in a manner that addressed" concerns from business managers and proved advantageous to a trade group that had lobbied for the changes, the SEC said, concluding that "business and market-share concerns influenced the substance of the criteria."
  • One of the top three rating firms took financial models that were developed by outside parties and used them for its credit rating process – without independently verifying their validity. It turned out that "errors in these third-party models resulted in changes to a substantial number" of the firm's outstanding ratings, the SEC said.
  • The SEC also uncovered instances of analysts having access to business performance data, such as market share, which could influence their decision making when assigning ratings. The failure to separate analysts from business activity was particularly egregious at one smaller rating firm, which allowed an analytical supervisor to participate in sales and marketing activities for ratings while also participating in determining those ratings.

The SEC's report does not name specific credit rating firms, other than indicating whether they were the three largest firms, S&P, Moody's and Fitch, or their smaller competitors. The SEC also made recommendations for improving their procedures to avoid the problems identified in the report. In statements reacting to the SEC's report, S&P, Moody's and Fitch each said they continue to enhance their policies and procedures.

Rating criteria – the standards that agencies use to evaluate repayment risk across various types of debts – are not supposed to be negotiated for the sake of winning business. But ProPublica found evidence that criteria for tobacco bonds — debts backed by payments from a massive 1998 settlement with cigarette manufacturers — were heavily negotiated by bankers.

In marketing documents collected by ProPublica across 22 tobacco bond offerings, bankers for UBS, Bear Stearns, Citigroup and others repeatedly took credit for getting the firms to bend their criteria. The raters earn hefty fees if they're chosen to rate an issue.

"Bear Stearns is the ONLY firm in two years to have negotiated new rating criteria pertaining to stress tests and tobacco sector fundamentals," the now-defunct investment bank said in a 2005 marketing document typical of the firm's claims of influence over the rating process.

After our story published, Wisconsin responded to a ProPublica public records request with a disc containing dozens of tobacco bond records dating to 2001. They include more claims by bankers saying they had swayed the rating firms.

In 2008, bankers from Lehman Brothers told Wisconsin that S&P had agreed to hear arguments for rating the state's tobacco bonds "even if" the debt couldn't satisfy the firm's "newly-minted, more stringent" rating criteria, according to a proposal submitted by the bank three days after its historic Sept. 15, 2008, bankruptcy.

In a 2007 document from Wisconsin, Bear Stearns said Fitch had published new rating criteria specifically in response to demands it made during a Puerto Rico tobacco deal. The criteria were "negotiated in their entirety during the rating process for our Puerto Rico tobacco transaction," Bear Stearns said in a proposal to handle a potential deal by Wisconsin.

Asked about the document, Fitch said no banker or outside party "unduly influenced" its ratings decisions for tobacco bonds. In statements and interviews, Moody's and S&P also have denied changing their rating criteria for the debt in response to demands from investment bankers.

In 2013, the Justice Department sued S&P for "falsely" representing that "its ratings were objective" when it rated subprime mortgage debts, seeking $5 billion in damages. S&P has said in defense that its ratings simply reflected its "current best judgments" about the debts. The firm may be nearing a $1 billion settlement of the mortgage ratings lawsuit, The New York Times reported on Monday.

Like many of the mortgage securities at the heart of that lawsuit, the riskiest tobacco bonds are now headed for eventual default.

Though the bonds are backed by money states and other governments get under the 1998 tobacco settlement, the amount of the annual payments is linked to cigarette sales, which have fallen faster than expected. That's forced some states and counties to engineer bailouts.

Last August, the SEC adopted rating agency reforms aimed at strengthening the separation between staff who perform the analytical work and business managers.

The reforms hadn't taken effect when the SEC conducted examinations summarized in its report. The new rules will be fully phased-in by June.

Bill Harrington, a former Moody's analyst who looked at ProPublica's collection of tobacco bond documents and the SEC's new report, said he doesn't think the rating agencies have changed.

Until 2010, Harrington worked in the Moody's division that rated complex securities at the heart of the financial crisis. He said he frequently saw managers, analysts and their teams make changes to rating criteria on the fly to satisfy business concerns, such as winning deals and market share.

In comments submitted to the SEC, Harrington has issued similar critiques, helping expose some of the rating-agency conflicts that contributed to the financial crisis. A Moody's spokesman had no immediate comment on Harrington's remarks.

The SEC's latest examination report, Harrington said, shows evidence of more of the same.

"The ugly picture that you saw in 2008 can just repeat itself," Harrington said.

Related coverage: Read more of Cezary Podkul's coverage of tobacco debt.

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