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WHO RATES THE RATERS (#2)

February 5, 2015

WHO RATES THE RATERS (#2)?

I wrote some time ago of the problem that Moody’s had in rating securities paper for  clients who paid Moody’s for such “independent judgment ratings” leading to a reliance of innocent investors who  were scorched in their investments in  such securities in part based on such “independent judgments.” Now it appears that Standard & Poor’s is taking its knocks as well in a lawsuit just settled which I will discuss later in this essay. I was moved to write the following after reading an article by AP in the newspaper that the lawsuit had been settled and thought the details of the settlement revealing and worthy of public notice – and I hope – scorn. Risk assessment for sale cannot be tolerated.

In the law, there is a built-in conflict of interest when there has been a relationship between, say, a judge who was formerly a member of the board of a corporation that is now a party to litigation before him or her. Such a judge is expected to remove him or herself from such a case not necessarily because a judge in such a case would favor his old corporation. The judge must ethically remove him or herself from the case because of appearances. Perceptions are important to public respect not only for the law but for how the law is administered. Administration of justice must not only be fair; it must appear to be, as the saying goes in the profession.

The fundamental problem in having banks pay rating agencies for ratings of mortgage and other paper that can be packaged and marketed as mortgage and other securities by the banks is the common knowledge that when you pay somebody you expect to get something for your money, whether it’s groceries, a new car, an insurance policy or whatever. In the case of Moody’s Investors Service, Standard & Poor and Fitch Ratings and less well known rating agencies, it is reasonable to suppose that the banks expected something for their money as well, such as improved levels of rating risk which make the bank’s products more marketable, which was provided in this case by Standard & Poor. So what did the banks get for their money? Let’s backtrack with a look at Standard & Poor’s rating services and the suit.

Two years ago the U.S. Justice Department sued Standard & Poor for failure to warn investors that the housing market was starting to collapse in 2006 because doing so would hurt its ratings business. The suit was settled just recently with an agreement that the agency will pay a chump change penalty of $1.38 billion dollars (on trillions of dollars in mortgage securities sold by the banks based on S & P’s rating advice). Details of the settlement agreement tell the sordid story of a ratings agency that put its bottom line over the exposure to loss to investors who relied on such ratings in buying trillions of dollars of mortgage securities the banks peddled, the same banks that paid S & P for its risk assessment of such paper. (Whether banks paid a bonus for better ratings is not discussed in the settlement agreement.)

Under the settlement agreement, S & P acknowledged it issued and confirmed positive ratings despite KNOWING (my emphasis) those assessments were unjustified and in many cases based on packages of mortgages S & P KNEW (my emphasis) were likely to default. In my opinion, negligence in rating is one thing but deliberate and knowing understatement of risk that innocent investors rely upon is quite another, morphing from human error to knowing fraud. Making things even worse, S & P was apparently so greedy for bank rating fees that it ignored its own senior analysts who warned that the company had given top ratings to financial products that were failing to perform as advertised. It seems to me that when corporate management in its zeal to fatten bottom lines does not even listen to its own people,   then you have a systemic problem within the internal corporate structure and that heads should roll.

The Big Three rating agencies (Moody’s, S & P and Fitch) have been blamed for helping fuel the 2008 crisis by giving strong ratings to high-risk mortgage securities since such ratings made it possible for banks to sell trillions of dollars’ worth of such securities to such customers as pension funds (which may only buy securities that carry high credit ratings) and other such funds which are required by law or by charter to invest only in securities with high ratings. Credit rating agencies which in essence misrepresent the degree of risk associated with purchase of such securities are in a position to create havoc in the financial marketplace. They are not rating widgets; they are rating investment risks for firemen, police, nurses and millions of others whose pension funds are at risk as a result of the greed (and probable fraud) of the raters themselves. This cannot be tolerated. They need regulation big time.

Fortunately, and after being badly burned by Bush’s Great Recession and massive losses of homes to eviction, underwater sales etc., a 2010 congressional mandate required the SEC to enact a series of rules for the rating agencies whose under-regulated shenanigans helped bring on the disaster. Such rules, among other things, require the rating agencies to provide more details about how they determine each rating. The new rules also attempt to end inner-agency conflicts of interests by barring the raters’ sales teams from participating in the ratings process. The raters are also newly required to review and perhaps revise their ratings in cases where an employee was later hired by a company he or she evaluated, provide an annual report showing how they monitor ratings, how each rating changed over time, and whether the securities or companies involved later defaulted.

Will these band-aid regulatory patches solve the systemic problems within the raters’ corporate culture of greed and ratings for sale so that their ratings of risk assessment can once again be relied upon by the investing public? I am not optimistic that internal reform is in the works within their inner circles given their record to date and given the power their ratings command in the securities marketplace. I suspect more regulation will be necessary to protect the buying public from their antics.

So did the punishment fit the crime, as the saying goes? Did a measly $1.38 billion dollar penalty even scratch the surface of our trillions lost as a result of their knowing wrongdoing in risk assessment of the securities they approved for purchase by pension funds and others? I don’t think so. Left to my own devices, I would have let them suffer the fate of going out of business just as the Arthur Andersen accounting firm was forced to do after keeping phony books for Enron and its suicidal CEO.  Phony books for profit – phony ratings for profit – what’s the difference?

I will end this offering with a quote germane to the issue of raters and ratings from an expert in the field of the securities market, James Cox, a Duke University law professor: S & P “got off pretty light, considering they helped bring down the world’s financial system.” I agree; very, very light!   GERALD    E

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