Wednesday, September 28, 2011

SEC looks at S&P use of 'dummy' assets in rating CDO

The Wall Street Journal reported that the SEC is looking at S&P and its use of 'dummy' assets in rating CDOs.

Whether or not the SEC pursues this case against S&P, the use of 'dummy' assets makes the case for asset level (loan-level) disclosure for all structured finance securities.  Simply put, the SEC is looking at the issue of how can you value/rate a security when you do not even know what is in the security.

Your humble blogger has been making this point about the need for current asset-level disclosure for structured finance securities since before the credit crisis.  Without this disclosure, market participants do not have all the useful, relevant information in an appropriate, timely manner.

It is nice that the US government in the form of the SEC has come out and formally agreed with me on the need for current asset-level disclosure for structured finance securities.
U.S. securities regulators are zeroing in on the use by Standard & Poor's of fictitious "dummy" assets when it assigned a triple-A credit rating to a $1.6 billion mortgage-bond deal that imploded during the financial crisis, according to a person familiar with the matter. 
S&P's parent company, McGraw-Hill Cos., said Monday that it had received a so-called Wells notice from the Securities and Exchange Commission. A Wells notice is the agency's warning to financial institutions that they could face civil charges. McGraw-Hill said the SEC is weighing civil enforcement action against the firm for its ratings on a collateralized debt obligation called Delphinus CDO 2007-1 issued in July 2007 as the housing market was taking a turn for the worse. 
The SEC is alleging violations of federal securities laws, McGraw-Hill said in a news release. The company said S&P has been cooperating with the regulator on its probe into Delphinus. A spokesman for the SEC declined to comment.
Lawmakers, regulators and investors have trained their cross hairs on S&P and its peers for assigning rosy ratings to thousands of complex securities that were later downgraded within the span of a few months, deepening the crisis. 
The S&P investigation is one of a number of probes by the SEC's enforcement division, headed by Robert Khuzami, into the complex mortgage-bond deals known as collateralized debt obligations. 
CDOs, which are pools of subprime mortgages and other assets that were sold in slices to investors, had emerged before the crisis as popular and profitable products on Wall Street. But the housing market's collapse exposed both the banks and their investors to billions of dollars in losses and left in its wake a raft of legal and regulatory headaches. 
S&P originally assigned its highest rating to the deal based on "dummy," or hypothetical, assets, then maintained that triple-A rating even though bankers had replaced them with lower-quality assets that didn't meet the firm's ratings standards, according to emails among S&P analysts that were disclosed in congressional testimony. 
Jack Chen, a former Moody's analyst who now runs his own consulting firm, said it isn't uncommon for credit-rating firms to use "dummy" assets to determine a final rating for a CDO, because some of the deals may have assets traded in later. 
What is problematic with S&P's rating of Delphinus is that the assets that replaced the "dummy" assets were of a lower quality than those hypothetical assets S&P had used to issue the ratings, said Mr. Chen, who has reviewed the S&P emails that were released. 
Frank Raiter, a former S&P managing director who had retired by the time Delphinus was rated, told lawmakers in April 2010 that S&P's dependence on fictitious assets that were later replaced by lower-quality securities "looks like a bait and switch."
Had the investors had current asset-level data, it would not have been possible to do a bait and switch.  Investors would have been easily able to see that the assets did not meet the quality standards that were represented in the offering documents and would not have purchased the deal.

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