MF Global Credit Rating Agencies Testify before Congress: Were They Asleep at the Wheel?
Sima Saran Ahuja | Bloomberg Law
Congress’s subcommittee on oversight and investigations (Subcommittee) held a hearing on MF Global, Inc.’s (MF Global) bankruptcy. The hearing’s second panel focused on the role of credit rating agencies in the months leading up to MF Global’s downfall. To that end, senior executives from Standard & Poor’s Ratings Services (S&P), Moody’s Investors Service (Moody’s), and Rapid Ratings International, Inc. (Rapid Ratings) testified about their respective agency’s coverage and analysis of MF Global. For a review of the first panel, see Former MF Global Risk Officers Testify before Congress: Did Corzine Ignore Risk Warnings and Oust Naysayers?, Bloomberg Law Reports® – Securities Law (Feb. 21, 2012).
S&P’s Coverage: History of MF Global Downgrades
Craig Parmelee, a managing director with S&P’s corporate and government ratings division, testified that S&P first rated MF Global in May 2007 and maintained a “triple B-plus” rating of the company until February 2008. At that time, the rating agency downgraded MF Global to a “triple B” due to losses from unauthorized trading and “high financial leverage.” When its new CEO, Jon S. Corzine, announced in 2010 that MF Global would be transitioning from a traditional commodities broker to a full service investment bank, S&P once again downgraded the company to a “triple B-minus,” “just one notch above speculative or non-investment grade status.” Parmelee noted that this rating was lower than that of S&P’s chief competitors. Parmelee further testified that S&P “noted that the strategy would likely result in the company taking on more proprietary trading positions, which in our view would be riskier than the company’s traditional broker business. We further stated this company’s risk management controls continue to be a work in progress.”
— Discovery of European Sovereign Debt Positions
In May 2011, MF Global, for the first time, disclosed that it had off-balance-sheet exposure to approximately $6.3 billion of European sovereign debt through repurchase to maturity (RTM) transactions. According to Parmelee, the “disclosure caused no discernible disruption in the capital markets” because the portfolio was comprised of highly rated sovereign bonds that would only result in losses if the sovereigns defaulted. As such, S&P maintained its rating of MF Global through the summer of 2011.
— MF Global Placed on Credit Watch for Potential Downgrade
In October 2011, however, the situation at MF Global began to deteriorate. According to Parmelee, the credit crisis in Europe, coupled with MF Global’s “disappointing” earnings report caused the firm’s investors and their counterparties to “become quickly and increasingly concerned about the firm.” Amid the concern, S&P attempted to obtain additional information about MF Global’s RTM portfolio. In response to its inquiries, MF Global executives told S&P that the company was “‘in its strongest position ever as a public entity.” The next day, however, MF Global reported a quarterly loss of $191 million. Despite Corzine’s continued statements touting the financial health of the firm, MF Global’s stock price fell approximately 50 percent that day. Parmelee testified that the day after the earnings announcement, S&P “placed MF Global’s rating on credit watch with negative implications, under review for a potential downgrade . . . reflect[ing] S&P’s view that continued volatility in the capital markets and low interest rates could further harm MF Global’s ability to generate capital.” S&P also noted the company’s RTM exposure and increased risk profile at that time.
— MF Global Receives “D” Credit Rating
On October 31, 2011, MF Global filed for bankruptcy. S&P immediately downgraded the company to a “D” rating. According to Parmelee, S&P did not believe that MF Global collapsed because of its RTM portfolio. Instead, he testified that “MF Global’s demise was driven primarily by a rapid downward spiraling of confidence among market participants and counterparties who questioned the firm’s transparency and its ability to attract and maintain investors and generate revenue.”
Moody’s Coverage: MF Global a Risky Credit
Richard Cantor, chief credit officer of Moody’s, testified that “for several years, Moody’s viewed MF Global as one of the riskiest credits among all U.S. banks and securities firms.” Underlying this view was the notion that MF Global particularly was reliant on customer and counterparty confidence and had “speculative characteristics.” Cantor summarized Moody’s early ratings of MF Global “as not particularly strong.” In 2008, Moody’s rated MF Global at “BAA-1″ with a negative outlook. It downgraded it to “BAA-2,” and by the end of 2010, this rating carried a negative outlook. In February 2011, Moody’s reaffirmed MF Global’s negative outlook and identified three areas of concern: (1) earnings; (2) leverage; and (3) risk. In August 2011, without any improvement in these three areas, Moody’s indicated that it likely would downgrade MF Global again.
— October 2011 Meeting Precipitated Series of Downgrades
On October 21, 2011, Moody’s analysts met with Corzine and other MF Global executives in advance of its quarterly earnings announcement. According to Cantor, Corzine made clear that the RTM transactions were “purely proprietary trading positions” and that the company would report a “significant” loss. Acting on its August 2011 prediction, on October 22, 2011, Moody’s downgraded MF Global’s rating to “BAA-3″ with review for further possible downgrade. Cantor echoed Parmelee’s description of MF Global’s final days and testified that “an accelerating flight of customers and counterparties rapidly took hold.”
As the crisis of confidence and liquidity gathered pace over the subsequent 48 hours, Moody’s downgraded its rating to “BA-2″ and kept the credit on review for a further possible downgrade.” Moody’s once again downgraded MF Global to “CAA-1″ when it filed for bankruptcy, and withdrew its credit rating altogether on November 15, 2011.
Rapid Ratings’ Coverage: MF Global in Category of Companies that Default
Distinguishing itself from Moody’s and S&P, James Gellert, CEO of Rapid Ratings, suggested that credit rating agencies were to blame for MF Global’s collapse because its “bankruptcy follows trends with other notable financial failures from the last 12 years in one way: agencies that were paid to provide professional opinions on credit risk failed to give sufficient warning of the firm’s risk.” Gellert noted that while S&P and Moody’s carried investment grade ratings for MF Global from 2007 until the brink of its demise, Rapid Ratings “provided two years of warnings that MF Global was a high-risk sub-investment grade entity.” Gellert further testified that the methodology used by his firm differed from that of traditional credit ratings agencies. For example, Rapid Ratings is a user-paid, not issuer-paid, firm. In addition, it uses financial statements and a proprietary software-based system to formulate ratings. This means that Rapid Ratings does not utilize market input or qualitative analysts, and it does not have contact with management bankers, investors, or advisers in the ratings process.
Gellert explained that Rapid Ratings gave MF Global a “23″ rating indicating a high-risk category and below investment grade. He further explained that Rapid Ratings’ “23″ rating was the “rough equivalent” of a “CCC-minus” rating, or “8 to 10 notches below where they sat for the big three agencies,” that include S&P and Moody’s. According to Gellert, the “23″ rating was the product of a “simple story” of MF Global’s decline in revenue performance, profitability, and debt service management over several years. For example, MF Global recorded losses for 10 of the last 16 quarters, and the last four quarterly losses increased by 68 percent. Challenging testimony earlier in the panel, Gellert testified that Moody’s and S&P “barely moved” their respective ratings during this time period. He concluded by suggesting that “it is time to require more timely ratings, more accurate ratings, and more competition.”
Committee Questions the Ratings Agency Executives
With the conclusion of opening statements, the Subcommittee questioned the panelists about various aspects of their testimony.
— Did Moody’s Review MF Global’s Form 10-Q?
Representative Randy Neugebauer asked Cantor if Moody’s had reviewed MF Global’s Form 10-Q filed in September 2011 that discussed a $150 million capital charge that the Financial Industry Regulatory Authority required in connection with MF Global’s RTM transactions. Cantor characterized the 10-Q as a one-page document and responded that it was not reviewed by a Moody’s analyst at that time. Representative Neugebauer pressed the issue suggesting that such a filing should have raised a red flag, but Cantor testified that the 10-Q did not raise a flag because it wasn’t “new information about the exposure but rather its capital treatment, and the magnitude of the change in capital requirements was not a particularly significant amount from a credit perspective.”
— Did Moody’s Misinterpret MF Global’s Form 10-K?
Representative Michael E. Capuano questioned Cantor about his testimony suggesting that Moody’s did not learn until October 21, 2011, that MF Global was engaged in proprietary trading. In Representative Capuano’s view, this indicated that Moody’s had not read MF Global’s 10-K filed in May 2011. While Cantor responded that Moody’s did read the 10-K, he testified that the rating agency was not aware of the off-balance sheet RTM transactions upon review of the 10-K.
Cantor added that the “inherent credit risk of [the RTM] transactions was fairly modest” because they consisted of highly-rated European sovereigns. He continued, however, that the trading strategy of taking on a “very large proprietary bet outside of its traditional business was a break from the strategy that we had understood they were taking.” Cantor later clarified that Moody’s was aware of the RTM positions in May 2011. It did not , however, understand MF Global’s “motivations” for the positions and how they were being managed until late October 2011. It was the motivations and change in risk appetite, not the positions themselves, which caused Moody’s to re-evaluate its rating.
Representative Capuano next questioned Parmelee about his testimony that the first time S&P learned of the off-balance sheet RTM transactions was upon review of the 10-K. Parmelee responded that S&P did not have advance notice of the RTM trades and that while he became aware of them in October 2011, his team learned of them through the 10-K. Parmelee further testified that the RTM reference in the 10-K did not cause S&P to change its rating because it believed that it “continued to be appropriate.”
— Was There a Surveillance Failure?
Representative Michael G. Fitzpatrick asked the executives about the surveillance methodology employed by credit rating agencies. Parmelee responded that S&P surveils companies on an on-going basis based on activity in the marketplace and that its ratings incorporate qualitative and quantitative aspects. Cantor added that Moody’s reviews financial statements and meets with the covered company. He noted that Moody’s had met with MF Global 15 times in a two-year period, reviewed its financial results, and asked it “probing” questions.
When asked if they stood by their ratings and methodologies, both Parmelee and Cantor responded that they did. More specifically, Representative Fitzpatrick asked the executives if not immediately reacting to the European sovereign debt position in May 2011, when they were initially disclosed, was a surveillance failure. Both Cantor and Parmelee testified that their respective MF Global ratings were appropriate and did not represent a surveillance failure.
— Why Did MF Global Fail?
Representative Fitzpatrick also challenged Cantor’s testimony suggesting that MF Global did not fail because of the European sovereign debt positions, but instead collapsed because of missing customer funds. Cantor stood by his testimony noting, “that was my understanding, that like many financial services companies in weakened financial positions and having liquidity strains, [MF Global was] seeking an acquisition partner and they were close to reaching an agreement along those lines, which fell apart when the customer money was missing.”
— Potential Conflicts and Lack of Transparency?
Representative Steve Pearce asked Parmelee whether he was aware that an individual named Richard Moore was working for Corzine and also was on S&P’s board of directors. Parmelee responded that he was not aware of that fact until recent press reports about the connection. Representative Pearce also questioned Parmelee about MF Global’s transparency regarding the RTM trades to which he responded, “I think they could have been more transparent than they were.” Regarding whether they thought off-balance sheet reporting was unethical, both Parmelee and Cantor testified that they did not think so.
— Did S&P and Moody’s Lack Diligence?
Representative Neugebauer closed the hearing by remarking that there is a “responsibility, we believe, in the rating community to make sure that if people are going to continue to have confidence in the system, that we feel like and that the public, more importantly, feels like the appropriate amount of due diligence is being done on your part. . . . [T]oday we have some concerns about that.”
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