The ‘Cartel’ Is Back: 8 Banks Caught Rigging Government-Bonds
First it was the Libor-rigging cartel, then the FX exchange-rate manipulation cartel, now, European regulators have moved on to prosecuting “anti-competitive” practices in euro-denominated sovereign bond markets. The ‘Cartel’ Is Back: 8 Banks Caught Rigging Government-Bond Markets
One month after the European antitrust regulators charged Deutsche Bank, Credit Agricole and Credit Suisse of being a part of a ‘bond trading cartel’, regulators are bringing a separate case against eight unidentified European banks alleging that they conspired to rigging euro-denominated sovereign bond markets.
Reuters reported Thursday that the European Union’s antitrust authority has charged the banks with operating the cartel behind 2007 and 2012.
Just like in past cartel cases, traders at the accused banks allegedly used chat rooms to share “commercially sensitive information and coordinated trading strategies” that they presumably used to rig markets to benefit their own trading books – and shortchange their “counterparties”.
If they’re found guilty, the banks could face fines equal to up to 10% of their global turnover.
“The Commission has concerns that, at different periods between 2007 and 2012, the eight banks participated in a collusive scheme that aimed at distorting competition when acquiring and trading European government bonds,” the Commission said.
“Traders employed by the banks exchanged commercially sensitive information and coordinated on trading strategies. These contacts would have taken place mainly – but not exclusively – through online chatrooms.”
Regulators told Reuters that they wanted to make one thing clear: The allegations aren’t meant to imply that euro-denominated bond markets are subject to pervasive “anti-competitive” practices (though maybe they should talk to Mario Draghi about that).
But don’t worry: We’re sure the information traded in these chatrooms fell neatly within the bounds of “market color.”
Inflated Bond Ratings Helped Spur The Financial Crisis. They’re Back.
Credit-grading firms are giving out increasingly optimistic appraisals as they fight for market share in booming debt-securities markets.
Times are tough for the Mall at Stonecrest in suburban Atlanta. The Kohl’s closed in 2016. The Sears shut in 2018, and the Payless ShoeSource finished its going-out-of-business sale in May. When a $90.5 million mortgage came due last summer, the mall’s owners defaulted.
Through it all, S&P Global Inc. has said a security tied to the mall’s mortgage wouldn’t lose money. S&P says the “situation is fluid” and “we won’t hesitate to revisit the rating.”
Inflated bond ratings were one cause of the financial crisis. A decade later, there is evidence they persist. In the hottest parts of the booming bond market, S&P and its competitors are giving increasingly optimistic ratings as they fight for market share.
All six main ratings firms have since 2012 changed some criteria for judging the riskiness of bonds in ways that were followed by jumps in market share, at least temporarily, a Wall Street Journal examination found. These firms compete with one another to rate the debt of borrowers, who pay for the ratings and have an incentive to pick rosier ones.
There are signs some investors are skeptical. Some bonds in markets where ratings criteria have been eased don’t trade at the high bond prices their ratings suggest they should. Investors have also shown skepticism about ratings on some corporate and government bonds.
“We don’t trust the ratings,” says Greg Michaud, director of real estate at Voya Investment Management, which holds $21 billion in commercial-real-estate debt.
The problem is particularly acute in the fast-growing market for “structured” debt—securities using pools of loans such as commercial and residential mortgages, student loans and other borrowings. The deals are carved into different slices, or “tranches,” each with varying risks and returns, which means rating firms are crucial to their creation.
The Journal analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019. The data, compiled by deal-tracker Finsight.com, allowed a direct comparison of grades issued by six firms: majors S&P, Moody’s Corp. and Fitch Ratings, and three smaller firms that have challenged them since the financial crisis, DBRS Inc., Kroll Bond Rating Agency Inc. and Morningstar Inc.
The Journal’s analysis suggests a key regulatory remedy to improve rating quality—promoting competition—has backfired. The challengers tended to rate bonds higher than the major firms. Across most structured-finance segments, DBRS, Kroll and Morningstar were more likely to give higher grades than Moody’s, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe.
“The victims are the investors,” says Marshall Glick, a portfolio manager at investment firm AllianceBernstein LP. He was among a group of professional investors who in 2015 complained about inflated ratings to the Securities and Exchange Commission and asked the agency to make it harder for issuers to cherry-pick the best ones, internal SEC memos show.
The SEC didn’t implement their recommendations, multiple meeting participants say. Jessica Kane, director of the agency’s credit-rating division, declined to comment on the investors’ concerns, saying through a spokeswoman: “We encourage anyone with comments, recommendations or concerns to reach out to us.”
Rating firms say they don’t let business influence ratings. “Just having a higher or lower rating on a deal doesn’t make you more or less aggressive. It just either makes you wrong or right in the long run,” says Kunal Kapoor, chief executive officer of Morningstar, which acquired DBRS last month. “I stand behind our methodology.”
Moody’s says “the regular adjustments we make to our models, methodologies and assumptions reflect evolving market conditions.” Fitch says “we are focused solely on getting the credit right.” S&P says “we compete on analytical excellence” and “no ratings business model is immune from potential conflicts of interest.” Kroll says that since its 2011 market entrance, “we have forced incumbent agencies to do better research and reexamine underserved sectors that they previously overlooked.”
After the financial crisis, ratings firms were criticized for taking lucrative fees and giving high grades to risky securities that caused big losses for investors. S&P paid $1.5 billion to resolve crisis-era litigation, admitting it set out to change rating models to benefit market share but not admitting wrongdoing. Moody’s settled for $864 million without admitting wrongdoing.
Investor reliance on credit ratings has gone from “high to higher,” says Swedish economist Bo Becker, who co-wrote a study finding that in the $4.4 trillion U.S. bond-mutual-fund industry, 94% of rules governing investments made direct or indirect references to ratings in 2017, versus 90% in 2010.
Strong bond issuance and a rebound in the lucrative structured-securities market have brought good times back to the rating industry. SEC disclosures show fees for rating structured deals can top $1 million. Industry revenue rose 20% to $7.1 billion in 2017 from 2016, the most recent SEC data show. S&P’s and Moody’s shares are up more than eightfold in the past decade, and their stocks hit all-time highs last week.
Two fast-growing structured-bond sectors are commercial mortgage-backed securities, or CMBS, and collateralized loan obligations, or CLOs. CMBS fund deals for hotels, shopping malls and the like. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts.
In a May speech, Federal Reserve Chairman Jerome Powell compared CLOs to precrisis mortgage-backed debt: “Once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards.”
Behind the ratings inflation is a long-acknowledged flaw Washington didn’t fix: Entities that issue bonds—state and local governments, hotel and mall financiers, companies—also pay for their ratings. Issuers have incentive to hire the most lenient rating firm, because interest payments are lower on higher-rated bonds. Increased competition lets issuers more easily shop around for the best outcome.
The Four Seasons Resort Maui at Wailea, owned by billionaire Michael Dell and featuring oceanfront suites that can go for $14,500 a night, borrowed more and won higher ratings. In 2014, the hotel’s investment bankers hired Morningstar to rate a $350 million bond sale backed by the property’s mortgage. Morningstar gave ratings to six slices of the debt that ranged from triple-A, expected to withstand the Great Depression, down 14 rungs to single-B, susceptible to losses in a mild recession.
When the resort refinanced its debt in 2017 in a $469 million deal, bankers picked DBRS as one of two firms to rate the debt. DBRS had just loosened its standards for such “single-asset” commercial-mortgage deals. DBRS issued grades as much as three rungs higher on comparable slices rated by Morningstar in 2014.
DBRS’s market share doubled to 26% within months of the change, according to industry publication Commercial Mortgage Alert.
Morningstar in June 2018 revamped its methodology for these deals, and its market share swiftly rebounded. It was one of two firms the Maui hotel’s bankers picked to rate its next offering, a 2019 deal for $650 million. While the hotel’s income had grown since 2014, the debt increase meant various slices of the offering had less cash available to repay investors than in 2014. Morningstar issued grades as much as two rungs higher on comparable slices rated by DBRS in 2017.
That should have lowered borrowing costs. Instead, investors demanded yields above where Goldman Sachs Group Inc. and Barclays PLC investment bankers had initially hoped to sell the debt, say people familiar with the pricing.
DBRS referred inquiries to Morningstar, which says its Maui ratings partly reflected improvements at the resort and that the two firms’ methodology changes were meant to provide “greater transparency” to investors. A spokesman from Mr. Dell’s investment office referred queries to Goldman and Barclays.
Goldman referred reporters to a bond-offering document, pointing out disclosures saying bankers solicited “preliminary feedback” from six rating firms and hired two based on the size of their triple-A slices.
Another section of the document, which Goldman didn’t point out, warned investors they shouldn’t rely on ratings because “the recent credit crisis” showed their grades “were not, in all cases, correct.”
Rating analysts say their firms have lost deals because they wouldn’t provide the desired ratings. “I suppose that’s the flip side, isn’t it, of having more competition among rating agencies?” Huxley Somerville, a senior Fitch Ratings analyst, said in June after Fitch lost to another firm on rating a mall deal.
‘Incentives Are Wrong’
In the first half of 2015, S&P’s share of ratings in the $600 billion CLO market hit a five-year low, at 36%, according to data from industry publication Asset-Backed Alert, an affiliate of Commercial Mortgage Alert. That fall, S&P changed its methodology to make it easier for CLOs to get higher ratings. S&P rated 43% of debt in that market in the second half of 2015. In 2018, its market share hit 48%, still trailing Moody’s and Fitch. (Bonds can get more than one rating, so market share can total over 100%.)
When S&P again proposed loosening its criteria this year, a group representing more than 100 professional bond investors wrote a letter to the company, reviewed by the Journal, saying the changes “will lead to a weakening of credit protection for investors at a time where we need it most.”
S&P proceeded. It says the changes “take into account the evolution of the CLO market over the past decade.”
David Jacob, who joined S&P in 2008 to head its structured-finance sector, says he ran monthly reports explaining to his boss why S&P wasn’t selected to rate deals. The answer was almost always that its criteria were tougher than another’s.
“Little by little it weakens,” says Mr. Jacob, who lost his job in a reorganization in 2012 and is retired. “If you have the tightest criteria, who’s going to use you?…The incentives are wrong. They stayed wrong.”
Investors say ratings inflation is most evident in commercial-mortgage-backed securities, or CMBS, of which investors hold about $1.2 trillion. The Journal found DBRS rated these bonds higher than S&P, Moody’s or Fitch 39%, 21% and 30% of the time, respectively. It rated bonds lower 7% of the time or less. Morningstar rated the bonds higher than the big firms at least 36% of the time and lower 2% to 8% of the time. Kroll showed similar trends.
When rating a security higher than their three big competitors, Morningstar, Kroll and DBRS were around two rungs more generous, on average. Some ratings were a dozen or more rungs higher, potentially the difference between junk bonds and triple-A.
A spokeswoman for Kroll and spokesman for Morningstar, which now owns DBRS, said there is a bias in the data because when smaller firms put forth more conservative feedback on where they might rate deals, they are often not chosen to rate them. DBRS and Morningstar say that if these unpublished ratings could be reflected in the data, the results might look different.
S&P and Moody’s were about as likely to rate the same debt higher or lower compared with one another. Fitch showed a slight tendency to rate higher more often. Moody’s and S&P declined to comment on the Journal’s analysis. Fitch says “diversity in credit views is a positive for investors” who are “aware of the differences between rating agency criteria and make informed investment decisions accordingly.”
Moody’s, S&P and Fitch responded to increased competition by issuing higher ratings, according to two academics’ study of 2,488 securities rated between 2009 and 2014. One author, Colorado State University Finance Professor Sean Flynn, says “competition among credit-rating firms has, if anything, reduced the quality of credit ratings.”
In October 2015, Moody’s eased its rating methodology for single-asset CMBS deals like the one in Maui. Moody’s change led to upgrades of up to four rungs on some slices of about half of single-asset deals it rated. Its market share rose to 54% in the first half of 2016 from 28% during the second half of 2015, according to Commercial Mortgage Alert.
Fitch saw similar growth in another corner of the CMBS market in 2016 after giving itself wider latitude to use easier rating assumptions. The firm was hired on every multi-borrower CMBS deal in the second half of 2016, up from 80% market share during the second half of 2015. Fitch says: “This new criteria merely aimed to better reflect what we do.”
Moody’s ratings on riskier slices of these multi-borrower deals often weren’t as favorable as those of its competitors. By 2015, issuers “essentially stopped soliciting our ratings” on those slices, according to a January commentary from the company.
Investors demanded higher yields on triple-B portions of deals without Moody’s ratings than on triple-B slices that included Moody’s during 2011 to 2014, according to a Journal analysis of Commercial Mortgage Alert data. The difference was about three-tenths of a percentage point more, on average, than benchmark triple-B rated CMBS—which means it was costlier to borrow than comparably rated debt.
Adam Hayden, who manages a $13 billion securities portfolio at New York Life Insurance Co.’s real-estate-investment arm, was among the investors who met with the SEC in 2015. He said inflated ratings were a risk to market stability, according to a meeting memo obtained by the Journal.
The portfolio he manages holds about $10 million of a security called BACM 2005-1 Class B—the bond backed by the Mall at Stonecrest mortgage. When sold in 2005, the bond contained around 140 mortgages and earned high grades. As mortgages were paid off, the debt pool shrank. Stonecrest’s mortgage now accounts for 97% of the bond, according to commercial mortgage tracker Trepp LLC.
S&P downgraded the bond three times, keeping it at investment grade despite the default. Fitch in April downgraded the bond deep into junk territory citing “increased loss expectations.”
Inside the mall, next to the former Payless ShoeSource, sits a storefront that until this spring housed a bookstore owned by Monique Hall. Sales were so weak she filed for bankruptcy, she says. “This particular mall,” she says, “is on life support.”
Craig Delasin, CEO of the mall’s management company, Urban Retail Properties, says owners are finalizing a deal to extend the loan’s maturity and that the mall is signing up new tenants.
Stonecrest Mayor Jason Lary in 2017 made an unsuccessful effort to attract Amazon.com Inc. ’s new headquarters by offering to rename part of the city Amazon, Ga. He compares himself to a physician trying to help a sick patient. His prognosis for the mall: “a 50-50 chance of survival.”
Meanwhile In The US…
Muni Mis-pricings Seen Stinging Taxpayers For Up To $25 Billion
Every time America’s states and cities sell bonds to build new roads, schools and bridges, they may be leaving a big chunk of money on the table. Investment banks, which governments hire to line up buyers for their bonds, routinely underprice the securities, delivering gains to early investors at taxpayers’ expense, according to a study by Fideres Partners LLP, a London-based consulting firm.
It found that bond prices increased by an average of 1.6 percent soon after they were first sold — indicating governments could have raised over $25 billion more from 2006 to 2015 if the debt was sold at those higher prices.
“The reason why these bonds trade so heavily and go up in price so much right after issuance is because people think the issuers overpaid — that that bond is worth more,” said Alberto Thomas, who worked on the study. “Someone in that process has not done their job properly.” The $3.8 trillion municipal-bond market is the key way that local governments finance construction projects, so any failure to adequately price the securities would be felt broadly. President Donald Trump has sought to encourage states and cities to pump more money into airports, roads and other infrastructure, some of which was neglected as governments dealt with the economic fallout of the Great Recession.
Other research has raised questions about the efficiency of the municipal market. A study released more than a decade ago by professors at Carnegie Mellon University found “substantial” underpricing of new issues. And others have asserted that governments could save money by selling their debt more frequently in competitive auctions, instead of the typical practice of relying on underwriters picked ahead of time.
Fideres, which also studied the rigging of the Libor benchmark interest rate and often prepares research for use in class-action lawsuits, looked at 8,000 tax-exempt bond issues sold between 2006 and 2015 worth about $1.1 trillion. It was limited to fixed-rate deals above $50 million sold through both negotiated and auction sales. The price increase from the day the bonds were awarded until the the settlement date was “abnormally high” compared to other asset classes, the report said. Corporate bonds rose about 0.64 percent — less than half as much as the munis — while U.S. Treasuries gained 0.33 percent, the firm said. Fideres has previously asserted that the gap shows that corporate debt is being “systematically underpriced,” too.
For municipal bonds, those early increases have been shrinking, potentially because low interest rates — which have pushed up debt prices — have given the securities less room to rise. In 2010, prices rose an average of 1.88 percent between the initial pricing and the close date, according to Fideres. That shrank to 0.85 percent in 2015.
The Securities Industry and Financial Markets Association, the trade group for underwriters, hadn’t seen the study and declined to comment, spokesman Katrina Cavalli said. Underwriters may have a reason to underprice securities: They often retain a portion of the bond issue after a sale, which means they’ll benefit if the price climbs, the report said. “Knowing a bond price will increase shortly after issuance allows them to generate trading profits, incentivizing them to set lower issuance prices,” the report said.
Companies Slow to Adopt Libor Replacement
Borrowers led by Fannie Mae have sold $105 billion of floating-rate securities linked to SOFR since it made its debut nearly a year ago.
Companies are dawdling in their adoption of the Federal Reserve’s preferred replacement for the interest-rate benchmark underpinning trillions of dollars in financial contracts.
Borrowers led by Fannie Mae , the federal mortgage finance agency, have sold $105 billion of floating-rate securities linked to SOFR, the secured overnight financing rate, since it made its debut almost a year ago, according to CME Group Inc. In that period, according to Wells Fargo & Co., companies have sold more than $900 billion of debt tied to the London interbank offered rate, the old benchmark for variable-rate debt.
Libor, used to underpin everything from home mortgages to corporate loans, was slated for replacement in 2021 after a manipulation scandal and finding a replacement is a key challenge for banks, companies and investors. Each wants a reference rate that reflects the risks from short-term lending and is supported by a liquid market that behaves in a predictable manner. Properly setting the rates on business and consumer loans can determine whether such loans are affordable for borrowers and profitable for lenders.
Regulators and banks, including Bank of America Corp. , Citigroup Inc. and JPMorgan Chase & Co., in 2014 formed a working group—known as the Alternative Reference Rates Committee—to help create SOFR. The group is ahead of schedule in meeting its key goals, said Brian Grabenstein, who leads Wells Fargo’s Libor transition efforts and is a member of the committee.
While the group says adoption is happening at a rapid pace, “that’s not really the sense I get when speaking to our clients,” said Mark Cabana, head of short-term interest-rate strategy research at Bank of America Merrill Lynch.
Companies are in “a state of paralysis” as they await the creation of longer-term SOFR rates, he said.
Fannie Mae has sold $15.5 billion of SOFR senior unsecured debt since last July and no Libor debt. But it continued to use Libor when selling $10 billion of mortgage and risk-transfer securities.
“We think it’s important for not just Fannie Mae, but for other market participants, to prepare for a world without Libor,” a representative for the mortgage company said in response to emailed questions. “Each product is evaluated independently given that they trade in different markets and have different investor bases.”
In October, Toyota Motor Corp. raised $500 million in the first nonbank SOFR commercial paper offering. While it continues to sell Libor-linked debt, “we are aware that Libor may cease to be quoted after 2021,” said Nicholas Ro, manager of sales and trading for Toyota Financial Services. “That’s why we took steps to use SOFR starting in 2018 to begin our transition process.”
SOFR is seen as more reliable than Libor because it is derived from the rate to borrow cash overnight using U.S. government securities as collateral. These trades are known as overnight repurchase agreements, or repos. Libor is set by a group of banks in London that provide estimates of the rate at which they could lend to other banks over various periods. Those estimates take into account the risk the borrowers won’t repay the debt.
The repo market is also vastly larger than the market for short-term bank loans, which has shrunk since the financial crisis.
The Fed’s working group is also reaching out to designers of accounting and trading systems about speeding development of products that can function with the new rate. Many investors and companies can’t buy or sell debt linked to SOFR because their accounting and trading systems aren’t properly configured for it, said Venetia Woo, principal director of North American regulatory strategy at Accenture.
“The reality is, people want to trade and people want to hedge,” Ms. Woo said. “Physically their infrastructure is not ready for it.”
The Fed last month released a paper written by two central bank economists describing a method to calculate longer-term SOFR rates using prices from futures contracts. Analysts have said this kind of term structure could make selling floating-rate debt linked to SOFR more attractive for companies.
Fed officials are seeking more trading data on SOFR-linked futures and interest-rate swaps because they are reluctant to push new structures to market without ensuring they work, analysts said.
However, collecting repo trading data isn’t a simple matter, especially for the smaller, more diffuse market of repo trades that are longer than overnight, so-called term trades.
Many players in the repo market—such as hedge funds and asset managers—aren’t regulated by the Fed. Officials have met with vendors in the repo market to discuss data collection, but it isn’t clear how quickly that effort might come together.
“Market participants are not uniformly comfortable in sharing those data with the broader market,” said Glenn Havlicek, a former banker who is now chief executive of GLMX, a technology company that provides tools to repo trading firms. The ‘Cartel’ Is Back, The ‘Cartel’ Is Back,The ‘Cartel’ Is Back, The ‘Cartel’ Is Back, The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back,The ‘Cartel’ Is Back