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United States v. Standard & Poor's

February 5, 2013



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


Comparing the Incomparable- Credit Ratings Agencies Revisited

January 17, 2012
Comparing the Incomparable- Credit Ratings Agencies Revisited

By R. Tamara de Silva
January 17, 2011

Yesterday, Standard & Poor's relieved the Eurozone's bail-out fund, the European Financial Stability Facility ("EFSF") of its AAA credit rating, possibly hampering the fund's ability to contain the European debt crisis. This comes on the heel's of the S&P stripping both France and Austria of their triple-A rating in favor of a rating of AA+.[1] The effect of the S&P downgrade may be negative. Ratings agencies exist to level asymmetries in information and evaluate risk but one of their inherent oddities is that they seek to compare things whose differences in scale make them incomparable. Ratings agencies also have conflicts of interests, they often evaluate financial products (like collateralized debt obligations) that they do not understand, they seem to lack fixed ways to measure absolute risk, and they are at times, catastrophically wrong.

Elephants and aardvarks

Downgrades should not be considered in a vacuum. When the ratings agencies equate economies based upon ability to repay debt, they artificially equate countries disregarding factors such as size, geo-political risk and political infrastructure that make their comparisons odd.

S&P announced on August 5, 2011 that it would downgrade the credit rating of the United States. Interestingly it announced during the last day of this same month that while the world's only superpower and largest economy would now get only a AA+ rating, securities backed by sub-prime home loans, the same type of investments that led to the worst financial debacle since the Depression (and one from which we have not yet arguably recovered) would receive its once coveted triple AAA rating...unlike the United States.

There is no question that the United States will be able to repay its debts, we will continue to print more money-the larger issue is the continual erosion in the Dollar over time. Although a currency cannot be devalued ad infinitum without catastrophic results, at least for the time being, there is no credible replacement for the Dollar continuing to be the world's reserve currency. No other nation has the assets to back up being the world's reserve currency.

Looking at the S&P's downgrade of the United States in a vacuum, one would think that it is more prudent (according to all three ratings agencies), to prefer Austria, Denmark, Norway, France, Germany, Singapore, Luxemburg, the Swiss or even Finland. There is no consensus by all three agencies on countries like Hong Kong, Australia and the Isle of Mann. Yet other than ratings, the similarity ends there. Comparing the United States, the largest and most analyzed economy in the world with relatively petite nations like Luxemburg and Finland are like comparing the teeth of an otter and an elephant-one is so remarkably larger than the other that a comparison seems problematic. Admittedly both animals have teeth. Or like comparing the speed of an elephant and an aardvark.

To put the utility of comparison between the United States, which has a GDP of $14.657 trillion, in perspective, here are the GDPs of some of the remaining triple AAA rated countries in 2010 according to the IMF [2] :

• Luxemburg has a GDP of $52.43 billion,
• Germany's GDP is $3.314 trillion (largest in the EU)
• France $ 2.582 trillion,
• United Kingdom $2.172 trillion
• Lichtenstein $4.83 billion
• China $10 trillion (largest behind United States)

Comparing the largest most innovate, most scrutinized economy in the world to a nation like China is humorous because in terms of actual accounting standards, any meaningful transparency, the complete absence of a stable democracy or political freedoms-China is a peasant country. When the United States is downgraded, there is no other United States to compare it to, so to some extent, the rating downgrade may not be absolutely everything the media proclaims it to be.

Effect of downgrade on United States so far

When the markets opened on the first Monday after S&P's downgrade of the United States, the benchmark 10-year Treasury bond's yield dropped to 2.5%. Price, which is inverse to yield in bonds, has continued to increase even approaching all-time historic levels. This past August, the 10-year yield dropped almost 60 basis points, piercing below 2% (lower than their historic all-time low in 2008 when Lehman Brothers collapsed). The demand for United States' Treasuries has increased dramatically immediately following the S&P downgrade.

If the United States were deemed less credit worthy (less likely to pay its creditors), then investors and bond holders would demand higher returns for buying any U.S. debt/bonds. The very ability of the United States to borrow money by issuing bonds would be jeopardized. The market has ruled against this logic and to a large extent against S&P-justifiably so.

Remember a government bond is a debt instrument issued by a national government denominated in that government's currency. United States Treasury securities are valued in US dollars-their price is in United States Dollars.

A risk-free interest rate is the nominal rate of return for an investment with no risk (no credit risk) [3] of financial loss. The risk-free rate of return for almost all this century was the yield of United States Treasuries.


Why would the market seemingly disregard the opinion of S&P? Perhaps because many people remembered that during the housing bubble, sketchy loans (once again I proffer this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. S&P's granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused $2 trillion in losses to everyone that relied on them-basically, everyone. No one else seemed to find it ironic that this same agency told the United States by how much it thought its debt should be lowered.

Conflicts of interest and fraud

But back to the credit ratings agencies... Not that long ago, in August 2010 and again in July of 2010, the SEC threatened to charge all three ratings agencies with fraud. Some would say better late than never. During the housing bubble, sketchy loans (I use this as a new legal term of art) were repackaged by investment banks into investment pools and other mortgage backed securities and received the gold standard of financial ratings, the coveted and in theory elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody's. The agencies' granting of triple AAA ratings to companies and investment vehicles that turned into junk ratings caused billions if not trillions of dollars in losses to everyone that relied on them-basically, everyone. The credit ratings agencies are paid by the issuers (their clients) of the securities they were supposed to evaluate, creating an inherent conflict of interest. They were the game's referee and one of its players at the same time.

The SEC report on Credit Ratings Agencies from June 2007 identified another problem other than having the referee in a match being paid by one of the sides, (not the investors or the public's side mind you), that prevented the agencies from giving accurate ratings. The 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 the inability of agencies to understand what they were analyzing.

One could argue that the agencies were not engaging in a deliberate (alright not a horribly deliberate) fraud, that is having a public position of trust, being paid and knowing they cannot do what they are assigned to do but pretending to do it anyway. Mind you, if anyone else had engaged in this behavior, they would have likely been indicted for fraud and possibly RICO.

What may let the agencies off the hook is that they relied on the issuers' (the clients again, usually investment banks) audit committees. Audit committees cannot seem to be comprised of Chia Pets in human dimension. The fact that these committees represented having signed off on the financial instruments in question should mean something-if not, why have these corporate committees?!

Furthermore, one could argue that the credit ratings agencies must not be held responsible for their ratings because they did not and could not have understood the trading transactions taking place at the investment banks because they had to rely on the information they were given which was not itself transparent.

A possible longer term solution to the conflict of interest driven nature of the credit ratings agencies is to take away the compensation structure of the credit ratings agencies and deregulate them completely in-order to discourage inherent conflict of interest or use the Credit Spread Market-problem solved! Take away what is essentially a government-sponsored monopoly of credit ratings agencies and allow investor paid credit ratings agencies, which could open up the market and privatize the ratings industry. Without credit ratings agencies, the market will determine value more efficiently than the analysts at the agencies. A problem with this approach is that there might be variance between the ratings of twenty agencies as opposed to just three, causing the rating on any one agency to mean less and to make more work for risk managers.

No liability

S&P has somehow avoided to this very day, all criminal and civil liability for its part in the most recent financial crisis. If the agencies had some liability for their ratings, they may have a better incentive for assuring that they got them right. Neither the Justice Department nor the SEC (which has itself managed to miss all the major financial debacles of the past five years) has ever charged S&P with criminal conflict of interest (as they in practice do and would do to any number of much smaller economic participants with a much smaller fields of damage). Neither the Justice Department nor the SEC has gone after S&P for admitting before Congress in 2008 and 2009, that their being paid by the issuers (their clients) of the securities they were supposed to evaluate, created an inherent conflict of interest and did in fact wrongly influence their ratings.

Nobody has charged the S&P with criminal fraud or fraud on the marketplace for taking money from issuers in simple bad faith (playing the part of the referee and judge in a boxing match after being paid by one of the boxers) for rating securities, they admitted in sworn testimony they did not understand!

This sordid tale has no end. According to Bloomberg, S&P is giving its self-coveted triple AAA rating to junk,

"Standard & Poor's is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government.
S&P is poised to provide AAA grades to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties."

A spokesperson for S&P when asked about why it would give its higher rating of triple AAA yet again to subprime securities repackaged by many of the scions of AIG and Goldman that participated in causing the Credit Crisis and profited from its bailout simply stated, "We believe our ultimate success will be driven by the value investors derive from our ratings and analysis."
However, it is not honest, however much one is paid, to issue a triple AAA rating to what Bloomberg calls,

"More than 14,000 securitized bonds in the U.S. are rated AAA by S&P, backed by everything from houses and malls to auto- dealer loans and farm-equipment leases, according to data compiled by Bloomberg,"

and not the United States of America.

Relatively speaking

Size matters. Pension funds and many of the largest institutional investors have rules about what investments they may invest in and these rules are based on the ratings given to investments by the credit ratings agencies. Consider that Australia, Andorra, Bermuda, Canada, Cook Islands, Denmark, Estonia, Finland, Germany, Hong Kong, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom retain their triple-A ratings.[5] These countries represent less than 21% of the world's collective math may be slightly off. If investment funds were limited to investing in triple-A products, it would be preposterous to think that less than 21% of the economy of the world would fund the remaining 79%.

Another weakness of the credit ratings agencies is that there is no set standard employed for measuring absolute risk. What I mean by absolute risk is the measure in gambling parlance, of the risk of ruin. Wall Street and regulators have, in the example of a bank lets say, no better way other than asking for capital ratios to ascertain a bank's risk or ruin. Other factors, like the value of assets and counterparty transactions lack still, even in 2012, transparency.

Because the credit ratings agencies share this problem of being unable to objectively ascertain absolute risk, they lag the markets' own detections of absolute and relative risk. For example, the agencies did not foresee the Latin American debt crises, the European debt crisis, AIG, the Credit Crisis, Enron, Worldcom, or even MF Global. In this sense, credit ratings agencies look backwards better than they can look ahead. Arguably, there are extremely few economists or market participants that can look ahead-this may be a wholly unfair criticism...except this is part of the reason for having the ratings agencies.

The most obvious problems with the existing regulatorily instituted regime of three credit ratings agencies is that they have no competition, no real accountability because they have to be utilized even when wrong, and no liability. This oligopoly ought to be dismantled and the private sector should be allowed to get into the ratings game in the same way that analysts exists in the financial markets for every other type of investment. Doing so would eliminate the existing conflicts of interests within the credit ratings agencies and allow investors to pay the private ratings agencies for their research. Competition will have to drive the caliber of research and ratings upward.

Sadly, nothing in the gargantuan 2,300 page Dodd-Frank Act or that has been discussed in the Senate Committee on Banking, Housing and Urban Affairs addresses the problems with the credit ratings agencies...the same ones that contributed to our recent financial crisis.@

R. Tamara de Silva

Chicago, Illinois
January 17, 2012

R. Tamara de Silva is an independent trader and securities lawyer

1. The EFSF's ratings are derived from its backers and France and Austria were two of the largest guarantors behind Germany. S&P's downgrade of the EFSF will mean the fund has 440 billion less in Euros than before the downgrade.
2. These numbers are adjusted by PPP (purchasing power parity), basis-this takes into account, relative cost of living and inflation rates, rather than just exchange rates.
3. There are other risks like inflation risk (the principal returned on a debt instrument upon maturity would have less purchasing power) and currency risk (the Dollar could as it has, decline in value relative to other currencies).