Tuesday, February 12, 2013

“Governing by Intimidation?”

Sydney M. Williams

Thought of the Day
“Governing by Intimidation?”
February 12, 2013

On August 6, 2011, Standard & Poor’s downgraded U.S. debt from AAA to AA+, the first such downgrade in our nation’s history. Neither Moody’s nor Fitch followed suit. Last week the Justice Department filed a $5 billion lawsuit against S&P for alleged fraud related to the mortgage/credit crisis of 2008. Thirteen state attorney generals also filed suits against S&P and their parent, McGraw Hill. No suit was filed against Moody’s, nor was one filed against Fitch, despite the competitive nature and similarities of the rating business. All rating agencies must be sanctioned by the SEC.

A lower rating means higher costs for the issuers; thus the perverse incentive is to be liberal in the ratings. The ratings of instruments such as residential mortgage-backed securities (RMBSs) and collateralized debt obligations (CDOs.) tend to be similar, especially as it is the issuer who pays the rating agency. If one rating firm was found wanting, why weren’t the other two? Perhaps the answer lies in the fact that both Moody’s and Fitch kept AAA ratings on U.S. debt, while S&P did not?

Rating agencies are highly profitable. In an interesting article detailing the difficulty of breaking into that favored clique, Gretchen Morgenson’s column in Sunday’s New York Times, told the hapless story of a small firm, R&R Consulting, with what appear to be highly respected credit analysts. As of yet, they have been unable to break into the favored ranks. Their approach has been to work with investors, as opposed to issuers, but the principals of R&R realize that rating issues is more profitable. Because of the need to be approved by the SSEC, rating agencies are in effect government endorsed businesses, limiting competition and certainly not helping investors. It is another example, in my opinion, of crony capitalism.

After any crisis, there is the inevitable search for cause – for someone or some organization on which blame can be placed. There is no lack of suspects for 2008 credit crisis that almost brought the financial system to its knees. We were all culpable – government, banks, mortgage lenders, real estate agents, consumers and rating agencies. Bubbles are never the consequence of a few outliers; they exist because we were all complicit.

Government had long been interested in widening homeownership. Presidents and Congress promoted the entire subprime mortgage market, extending home ownership who could ill afford the obligation. As government sponsored enterprises, Fannie Mae and Freddie Mac have been examples of crony capitalism from the start. They have helped fund the campaign chests of politicians like Chris Dodd and Barney Frank, while they took undue risks that, while markets were working in their favor, paid off handsomely. Their executives made millions, which they willingly shared with their political backers. When markets declined, though, leverage worked against them and the house of cards tumbled. Banks created derivative products that allowed them to use exceptional levels of leverage, endangering depositors, all in the search for profit. Mortgage lenders, in many cases complying with government regulations, made “no-doc” loans, requiring little or no down payment. Real Estate brokers, hiding behind their slogan of caveat emptor, were motivated solely by transaction volumes. Consumers saw home prices rising endlessly, convincing themselves that values would never retreat. And rating agencies, competing for the opportunity to rate debt of issuers, were lax in terms of fiscal prudence.

Rating agencies have long operated in a strange milieu, with a clear conflict of interest. They are paid by the issuers whose paper they rate, not by investors whose capital is at risk. Banks, in many cases, were both issuers and investors. As Floyd Norris wrote in Friday’s New York Times, “in some cases, the banks that S&P is supposed to have defrauded are the very same banks that put together the securitizations.”

Caveat Emptor, a saying long associated with realtors, can be justifiably applied to issuers who first hired a rating agency and then, on the basis of the rating, sold paper to institutional buyers. As I wrote back on May 3, 2010, “Rating Agencies – Do We Need Them?”, “their demise would be filled by creative, entrepreneurial firms specializing in credit research, and whose clients would be investors, not issuers.” In a sense, it would seem that is what R&R Consulting is hoping to achieve.

Despite my questions regarding the integrity of the ratings issued by those like S&P and Moody’s, I find it curious that the Justice Department has decided to sue the one rating agency that downgraded the government’s own debt. One would have suspected that if one were guilty, all would be. Perhaps Mr. Holder is simply playing a game of tit for tat? Perhaps the DOJ is saying to the agencies, don’t tread on me?

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