Thursday, February 7, 2013

S&P Fraud Suit: A Case of the Pot Calling the Kettle Black

In a clear case of the pot calling the kettle black, the US Justice Department filed fraud charges against Standard & Poor's for its high ratings of securities loaded with bad mortgages, which played a major roll in creating the financial crisis. 

In Standard & Poor's Case Shows Obama Getting Tougher, the NJ Star-Ledger salivated over the federal government's fraud charges against S&P, one of the big 3 Wall Street rating agencies.

Citing a quote from this editorial, I left these comments:

"The bad behavior stems from a built-in conflict of interest. S&P’s job is to rate bonds so that investors can manage risk. But the firm, like the other ratings firms, is paid by the bank that issues the bonds."

Did you know that S&P, Moody's, and Fitch originally charged the bond buyers to rate the bonds, but that it was the SEC, pressured by union and other pension funds, that forced the agencies to charge issuers instead? It was the government that created this built-in conflict of interest!

Did you know that the rating agencies S&P, Moody's, and Fitch are a government licensed oligopoly? Did you know that they are the only firms that the SEC allows to provide credit ratings on bonds bought by pension funds, institutional investors, and investment banks, effectively creating a legal shield from competition? Did you know that big institutional investors can not rely on any other rating agencies to meet regulatory and capital requirements like ERISA? Did you know that the SEC anointed these 3, and only these 3, NRSRO'S (nationally recognized statistical rating organizations)? 

It may be that S&P committed fraud, in which case they should be held civilly and criminally responsible. It may also be that they are an innocent victim being scapegoated by politicians trying to deflect blame and protect their friends.  After all, all 3 rated these bond highly. Could it be that Moody's is being spared because Warren Buffet is a major shareholder?

One thing is sure:  Dig below the surface, and everywhere one looks, one sees the corruptive paws of government intervention as the primary cause of the Great Recession.

The editors continue:

study by the Federal Reserve Bank of New York found that even before the financial crisis, the ratings agencies were wildly understating the risk of bond issues. From 2005 to 2007, half of the bond issues rated “AA” wound up in default.In the run-up to the crisis, S&P, along with Moody’s Investors Service and Fitch Ratings, routinely granted blessings to the notorious mortgage securities that were at the heart of the financial crisis.

Monday morning quarterbacking is a harmless pastime. But, when it comes from the pot directed at the kettle, it's downright despicable and destructive. 

Keep in mind that these agencies were rating mortgage bonds backed by a can't-lose asset--houses. What risk is there even in sub-prime, no-doc mortgages, if the underlying asset will always bail you out because it is always going up thanks to the Fed's inflationary policies? Our whole culture was caught up in the "house prices can only go up" syndrome, and the folks at the rating agencies were not immune to this. Keep in mind also that most of these bonds carried implied federal guarantees via Fannie and Freddie. Context is everything. From the bubble perspective of the time, these high ratings may have seemed to make sense. 

As John A. Allison notes in his book The Financial Crisis and the Free Market Cure:

[T]o a certain degree, the ratings agencies were misled by the Federal Reserve and Freddie Mac and Fannie Mae, like everyone else. By keeping natural market corrections from occurring, the Federal Reserve misled the ratings agencies about the risk in the economy. In addition, the Fed was projecting good economic times ahead. The massive understatement of their subprime portfolios by Freddie Mac and Fannie Mae also created a massive distortion of the size and intrinsic risk in the overall subprime mortgage market.

The editors further write:

It’s not clear why the Department of Justice has taken so long to make this case, but this show of backbone is a welcome change. The Securities and Exchange Commission has allowed most of the major offenders to escape with modest settlements that include no admission of wrongdoing.

If the editors had done their homework, the reasons for this would have been crystal clear. As Allison notes:

Because of this special approval from the SEC, these three rating agencies have an apparent certification of quality from a U.S. government agency. There is a presumption in the capital markets that the government-sanctioned rating agencies know how to grade the risk of financial instruments. 

The editors didn't do their homework, as is made clear from their criticism of Dodd-Frank: "The Dodd-Frank reform did nothing to fix the perverse incentive for bad behavior by these firms, and it is unlikely House Republicans would agree to tougher rules now."

"Tougher rules" are not the solution. The SEC rules are precisely the problem. The "perverse incentives" are a consequence of government involvement. To "fix" them, simply reduce government to it proper role of prosecuting fraud and enforcing contracts. Otherwise, get the SEC out of the ratings agency game.

In a free market, rating agencies that compromised their integrity and public trust by engaging in behavior that created conflicts of interest (like relying on the issuers of the securities they rate for their fees) would quickly be supplanted by more trustworthy rivals.

Statists like the Star-Ledger editors didn't do their homework because their ideological perspective won't allow it. Big government apologists are looking for scapegoats in the private sector, when the primary culprits are in seats of political power in Washington, where the financial crises was engineered by regulatory fiat and political affordable housing crusades. 

The real fraud is in the concerted and ongoing efforts of the statists both inside and outside of government to cover up the primary role of the government in the Great Recession. Don't hold your breath waiting for the real culprits to be prosecuted. Statists intend to use the myth of deregulation or lack of regulation that they created to scapegoat the private sector in order to fuel their self-serving ideological drive toward an authoritarian state.

Related Reading:

Cart this Cartel to the Dumpster, by Steve Forbes

The Financial Crisis and the Free Market Cure, by John A. Allison

The Housing Boom and Bust, by Thomas Sowell

Notes on the Sub Prime Cridit Crises


Mike Kevitt said...

Couldn't big institutional investers, each separately, set up their own in-house rating departments for their own use? Would that be against the 'law'? That might go against div. of labor, but the 'law' would be the culprit on that.

With due respect, I think Allison coddles the rating agencies & everybody else, when he says they were misled to a certain degree. The agencies and everybody are professionals in various fields, just like those who misled them. They were misled because they were going, basically, by their college indoctrinations, which they didn't examine at the time, nor since, & they're not going to now. All this is true of their misleaders. By their indoctrination, they are automatons, unstoppable by intellectual appeal. As such maybe they shouldn't be called professionals.

This incl. the seats of 'political'(CRIMINAL) pwr. in D.C. They took a while to file charges against the rating agencies because they were trying to figure out how to cover themselves by using the agencies as their shield. If the Star-Ledger editors, in the same indoctrination, were more familiar with their indoctrination & did their homework, they'd've been happy to wait, knowingly, saying nothing, until now, and would now gloat about it.

In their indoctrination, crime is an integral part, and each actor must take his turn at it. Those best at it can always shield themselves with appropriate others so they can always be criminals, but safely, as long as there's not enough people educated in a philosophy of reason to pose a danger to them.

Mike LaFerrara said...

I think you're right about why the powers in Washington are slow to prosecute. I also think there really wasn't much fraud in the private sector.

In retrospect, it's easy to see the bubble in full view. But, during those years, it's hard to separate legitimate economic forces from the distorting effects of government intervention, or how far the trend will go before reality sets in.

I think the broader point is the government's intervention into the ratings business, which set up the dynamics that led to the ratings disaster.