United States v. Standard &
Poor's
By R Tamara de Silva
January 5, 2013
The Department of Justice filed a civil lawsuit yesterday against
one of the of big three credit ratings agencies, Standard & Poor's
("S&P") and its parent company, McGraw-Hill, Inc.[1] The suit alleges that S&P
deliberately gave its coveted triple-A ratings to sub-prime debt in order to
win fees. The suit does not
address the structural conflicts of interest within the three credit ratings
agencies that are Nationally Recognized Statistical Rating Organizations
("NSRO"), nor will it address or cure any of the underlying causes of the
credit crisis. While there are
problems with the credit rating agency business model, it will be difficult to
prove that S&P knew any more than even the audit committees of the
investment firms on whom it relied, or the issuers of debt instruments
themselves. The suit will of
course result in the levy of a fine.
But while S&P's hands may not be entirely unsullied- far more
importantly to the untrained public eye, they are as good a scapegoat as any
other.
S&P is a credit rating agency whose business is to provide
credit ratings represented by letters from triple-A to D, in exchange for
fees. Federal laws require that
certain institutions only hold investments that have a credit rating of
"investment grade," but most of the financial world relies on credit ratings
agencies to weigh and measure risk, risk defined in terms of the credit
worthiness of investments and institutions. S&P is the largest of three credit ratings
agencies that is recognized by the Securities and Exchange Commission ("SEC")
as an NSRO. From 2004
towards the end of 2008, S&P assigned credit ratings on nearly $4 trillion
of debt instruments. In terms of
sheer size and credibility, despite this suit and skepticism of the NSROs
particularly in Europe, the world has no credible alternative to credit ratings
agencies and specifically nothing to replace, Standard & Poors.
Keep in mind that almost five years after the worst financial crisis
in United States history, the Department of Justice has yet to criminally
charge a single culpable senior executive or firm. If history is any guide, the Justice Department will reach a
civil settlement with S&P wherein the firm will agree, without admitting
any wrongdoing, to pay a fine that in relative terms, will have as large a
fiscal impact on S&P as the cost of one month's dry kibble would have to
the owners of the Grumpy Cat. The
suit asks for a fine in excess of $1 billion but these will typically be
negotiated down and the government has not latterly demonstrated a willingness
to go to trial with these suits.
Like so many Wall Street settlements reached over the past ten years,
the cost of the settlement fine imposed will ultimately be a pittance relative
to the quarterly earnings of the offending firm-S&P is not likely to become
the first exception to this rule.
There in the gilded annals of academic and economic theory yet
remains the tidy axiom that markets are self-correcting. It is thought that market forces of
supply and demand will drive out weaker competitors and bring in new ones
through their own determinative natural selection. It is not necessarily so. Yet this assumption is an inescapable cliché of economic
theory now unfortunately embedded into political discourse. This axiom ignores the asymmetrical
political and economic power of some market participants relative to others,
and the use of regulation to give some participants a structural competitive
advantage over others.
Self-correcting economic behavior occurs famously in the instance of
market bubbles like tulip manias, Internet stocks and real estate bubbles, all
of which eventually burst.
However, none of this bursting applies to credit ratings agencies.
Credit ratings agencies are often wrong, have been wrong and will
not, even under Dodd-Frank, need to be correct, much less try harder to do so,
or for that matter make any effort towards attempting to. All three credit ratings agencies
adjusted their triple-A ratings of debt instruments to less than investment
grade at virtually the same time the rest of the world figured out there was a
problem with them. In their
defense, S&P points out that credit ratings are, "forward-looking opinions
about credit risk. Standard & Poor's credit ratings express the agency's
opinion about the ability and willingness of an issuer, such as a corporation
or state or city government, to meet its financial obligations in full and on
time." [2] The problem is that by the time the
credit ratings agencies, self-correct, their statements are no longer forward
looking or even present looking but much more akin to being told how a movie
ends a few months after you have seen it.
Not that long ago, collateralized debt obligations were repackaged
during the credit bubble into investment pools and other mortgage backed
securities and collectively adorned with the gold standard of financial
ratings, the coveted AAA ratings of the largest credit ratings agencies, Fitch,
S&P and Moody's. The
credit ratings agencies gave their coveted and in theory elusive triple-A
rating to investments that were anything but credit worthy or in the best case,
possessed of a very mixed credit pedigree. The agencies' bestowal of triple-A ratings to companies and
investment vehicles that were junk and later discovered to be junk, caused
losses in the billions and trillions of dollars to everyone who relied on their
ratings--essentially everyone.
The role of the credit ratings agencies, was present from Goldman
Sachs' knowingly selling instruments it bet against in Abacus to Citigroup's
selling of investments it also bet against-all these transactions of a
seemingly knowing fraud were adorned with triple-A ratings. Triple-A ratings played an essential
role in the credit crisis- enough to make them arguably the largest "but-for"
causal culprit of the financial crisis.
"But for"
the credit ratings agencies bestowal of triple-A ratings on sub-prime debt
investments, the credit crisis would not have occurred. But the financial world does not
operate as simply as the liability model used by personal injury lawyers to
make someone pay for car accidents or anything resulting in a personal
injury. The financial world is incomparably
more complex and the causes of the financial crisis are many.
In a larger sense, the credit ratings agencies cannot help it. The fault lies with their business
model and that having no competition, they really can be wrong in the largest
possible way and not be "wrong" in the conventional sense.
The big three credit ratings agencies are bestowed with a monopoly
by the government and if the world did not like the big three credit ratings
agencies, it would find (with the exception of a few marginal players) that it
had precisely nowhere else to go.
Put another away, even after having the SEC accuse them of consumer
fraud, and being about as wrong as they can be, the big three credit ratings
agencies still rate 96% of the world's bonds. Sort of as Henry Ford was reputed to have said about
offering customers the choice of a new model T in "any color so long as its
black."
What
is more, their business model makes the ratings agencies operate within a
closed conflict of interest loop.
The credit ratings agencies are paid by the issuers (who are also their
clients) of the securities they were supposed to evaluate-this creates a
conflict of interest.
But the government, or specifically the SEC knew of the conflicts of
interest within the credit rating agency business model and approved of
them. In June 2007, the SEC
acknowledged that there might be a real problem having the referee in a match
being paid by one of the sides-not the investors or the public's side either. The SEC asked S&P for
documentation of how S&P handled conflicts of interests and after several
months of scrutiny, approved of S&P as a NSRO--again, after having vetted
the inherent conflicts of interest within S&P's business model.
The ratings agencies have lobbying power in Washington and every
interest in protecting their triopoly, which remains, even after the Credit
Crisis and the implementation of Dodd-Frank, wholly unscathed. But really, in the absence of any
alternative and near total dependency, the world has an interest in S&P
too.
The most persuasive mitigating factor against charging the S&P
or any of the credit ratings agencies with fraud is that they themselves relied
on the internal audit committees of their clients/issuers. The credit ratings agencies relied on
the audit committees of their issuer clients, which committees had signed off
and attested to the S&P and the other credit ratings agencies about the
value and risk profiles of the investments for which they sought ratings. Ultimately, unless corporate boards are
compromised of crony Chia pets distinctly and wholly incapable of bearing any
liability or culpability (a very real possibility upon even a cursory
scrutiny- and another discussion for another time), they ought to bear the
responsibility for misleading the credit ratings agencies, or simply not
knowing what they were doing.
Either the investment banks' audit committees were not qualified to
pass on these investments or the credit ratings agencies were not. What now seems obvious is that both the
credit ratings agencies and the audit committees were not sophisticated enough
to understand the investment products they were charged with scrutinizing. They approved of them anyway.
The credit ratings agencies could not give accurate ratings of many
of the instruments involved in the housing bubble and credit crisis because of
the complexity of the transactions involved and their inability to understand
what they were analyzing. Not
knowing what they were doing makes them at least guilty, if they were regular
market participants, (which they are not) of criminal fraud. They may have culpability because
they perpetuated a fraud on the marketplace by accepting money and using their
position of trust, as a government sanctioned arbiter or investments, to
pretend to pass on investments when in reality they did not know what they were
examining or did and had a financial incentive to lie. One thing is certain, were the credit
ratings agencies like any number of the two-bit individuals the Department of
Justice and SEC have prosecuted, one could say that the prosecution of fraud is
not disproportionately tilted towards the smallest financial participants, or
at least squarely away from the largest ones.
In theory, the credit ratings agencies exist to level asymmetries of
information. They are also
supposed to evaluate risk.
Unfortunately, the credit ratings agencies have conflicts of interests
and they evaluate financial products (like collateralized debt obligations)
that they do not understand. They
were far from alone in not understanding the debt instruments presented to
them. In 2007, even Ben Bernanke
thought the risk of sub-prime debt was contained. The ratings agencies, like most of Wall Street during financial crises seemed to lack fixed ways to measure absolute risk, and as a result
during financial crises, when you would most want risk models to work, they too
prove catastrophically wrong.
Moreover, as much as Wall Street was wrong in assessing its risk, so was
the government and many of Wall Street's largest institutions-so why merely
pick on S&P? Unlike all of the
players on Wall Street however, the credit ratings agencies are still the only
game in town. The Department of
Justice's civil suit will do nothing to change this.@
R Tamara de Silva
Chicago, Illinois
