David R. Henderson  

The Feds' Suit of S&P

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I found two pieces on the federal government's suit of S&P particularly interesting because both make important points I hadn't thought of.

First, the Wall Street Journal's editorial page take, which is titled "Payback for a Downgrade?" It's dec line is: The feds sue S&P but not Moody's for pre-crisis credit ratings. The Journal editors speculate that the reason the U.S. government singled out S&P and didn't go after Moody's is that S&P, not Moody's, downgraded government debt in 2011. Excerpt:

Meanwhile, a McClatchy Newspapers report says that it was around that time that Moody's, which did not downgrade the government, was dropped from the federal investigation. Ask any investor and he'll likely tell you that Moody's was equally awful in forecasting the mortgage debacle.

The Journal also points out the absurdity of suing a company for fraudulent products when that same government continues to force people to buy its products:
And to this day, more than two years after the Dodd-Frank law ordered their repeal, SEC rules still force institutions to follow the advice of these government-anointed credit raters. Therefore the more appropriate defendant for Monday's lawsuit would be the SEC. But as a modest first step before suing a company for $5 billion, shouldn't the government at least stop mandating its products?

Also, there's a freedom of speech/press issue here. Notice that S&P's attorney is the noted defender of the First Amendment, Floyd Abrams.

The second is by Marc Joffe, a former employee of Moody's. It's titled "The S&P Lawsuit: Can It Fix the Rating System?" Joffe raises two other possible reasons for the U.S. government singling out S&P, both of which he finds more plausible:

Two other options seem more likely: (1) the other two agencies may still be in settlement talks with DOJ [Department of Justice], or (2) DOJ has a better case against S&P.

Joffe highlights one part of the DOJ complaint that helps make his case for (2) above:
According to the complaint, S&P management instructed employees not to publish software and data updates that would have resulted in lower ratings. For example, pages 42-48 of the complaint detail how S&P management suppressed an update to the agency's LEVELS tool that relied on a much larger and more representative set of mortgages.

For some time now, Marc Joffe has been trying to figure out how to make the rating system better. Here's his terse summary of the current system of ratings:
Given the importance of ratings, we need alternatives to the way they are now produced, i.e. by for profit companies with known conflicts of interest using proprietary data and analytics together with closed door rating committee meetings.

And here's his alternative:
A much better alternative would be a system based on open source rating software, with fully transparent inputs and outputs, and no rating committee discretion. This fully open, fully deterministic approach controls biases regardless of whether the analysis is funded by investors, issuers, foundations or governments. It also allows a distributed peer review process to occur over the internet. An excellent case for open source ratings appeared recently on Naked Capitalism. PF2 has advanced this idea by supporting my Public Sector Credit Framework - a simulation tool for rating government bonds
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COMMENTS (22 to date)
Steve Reilly writes:

For what it's worth, Abrams has said he won't make this First Amendment case.

txslr writes:

Frankly, I don’t see how ratings are important at all, except for the fact that the government requires them.

Marc Joffe writes:

Ratings existed before the government mandated them. Moody's started issuing ratings in 1909 and they were not cemented into law by the Comptroller of the Currency in the mid 1930s. That's when the FDIC started and regulators were looking for some third party verification of the safety of bank assets.

Steve Sailer writes:

Warren Buffett owned 20% of Moody's, so the Obama Administration is reluctant to go after Moody's.

txslr writes:

A few things have changed since the mid-1930s that might have impacted the value of rating agency opinions...

David R. Henderson writes:

@Marc Joffe,
They weren't cemented into law in the 1930s? Or do you mean they were cemented into law in the 1930s?

Well, the ratings were essentially mandated by congress. They created the tri-opoly of Fitch, Moody's and S&P as the official, approved agencies that rated the securities that banks hold for regulatory capital purposes.

With Basel II ruling that AAA MBS were an advantageous way to hold that capital (allowed higher leverage), naturally banks wanted more such securities. Ask yourself, if you owed your privileged position as an official rater of securities to congress, if you'd be eager to pour cold water on those securities (sub-prime mortgages) that congress was also favoring?

MingoV writes:

The quality of the rating system has nothing to do with the federal government's lawsuit against S&P. The lawsuit is a direct retaliation for the reduced credit rating of US securities. The other complaints are a combination of window dressing and excuse to raise the "damages" claim to five billion dollars.

Milton Recht writes:

Rating agencies have maintained for many years that ratings are a relative measure of credit default risk and not a measure of investment risk. The loss of value in mortgage securities and derivatives at the beginning of the great recession preceded, and was in excess of, the actual defaults on the underlying mortgages. No rating agency has ever said its ratings measure investment risk, liquidity risk or price risk.

It was the loss in value of the collateralize mortgage securities and not defaults on the underlying mortgages that created the liquidity risk that caused the failure of Bear Stearns and the banking crisis.

The fact that banking regulators and the SEC expanded the use of the ratings beyond credit default to measure required capital levels is not the fault of the rating agencies.

The fact that the models were not updated or corrected to reflect higher expected losses is irrelevant if the relative valuations of the credit risk of the debt securities would be unaffected.

Credit ratings were never a measure of absolute risk. In recessions, all debt becomes riskier and more likely to default and not just mortgage debt. A higher rated security has an higher probability of default in a recession than in an economic boom period but its credit rating does not change.

The misuse of a credit rating by an investor or government agency is not the fault of the rating agencies.

Tom writes:

The rating agencies were "printing money" in the sense that AAA rated junk was allowed as Tier 1 capital for loans.

One key limit should be a maximum amount of AAA (or top) rated Financial products in any country, perhaps 100% of prior year's GDP. Once that limit is reached, new AAA financial products force downgrades in some other previously AAA rated stuff.

Higher granularity would be good, too -- perhaps a scale of 50-100 with 50 being the lowest investment grade.

Open source rating sounds like a winner, too -- and can even start already. Maybe Google ratings...

Marc Joffe writes:

@David: Thanks for the correction. There was no regulatory support for rating agencies until the mid 1930s when the Comptroller of the Currency limited banks to holding investment grade assets as defined by credit rating agencies. This decision was controversial at the time, drawing criticism from the Investment Bankers Association of America - a forerunner of SIFMA. Critics noted that ratings often performed poorly - and this was back before they were compensated by issuers.

@txslr: Ratings can and should serve a useful social function irrespective of regulation. Not everyone has the time or expertise to analyze fixed income investments. If credible ratings are available, this task is simplified. It's like buying a car: many people base their choice on Consumer Reports rather than testing every make and model themselves.

Shayne Cook writes:

@ Milton Recht:

Thanks for that explanation. I was in the process of attempting to write up something to that effect - and you beat me to it and probably did a better (more understandable) job of it.

ThomasH writes:

I think that downgrading the US Government should let them use an insanity defense.

txslr writes:

Marc,

Not really. To the extent that there is an active market in a debt security there is a price and hence a yield that reflects the risk of the future cash flows. If rating agencies provided any useful information beyond that already reflected in these yields you would expect to see the market respond to changes in ratings. But you don't. In fact, the market appears to move in advance of rating changes, suggesting that rating agencies are, in effect, reporting what the markets already know.

So, unless you can conjure up a social value from reporting already public information, I have a hard time figuring out what purpose rating agencies serve beyond that mandated by statute or regulation. Perhaps this explains the odd business model they operate under, in which the companies being rated rather than the recipients of the information are paying for it.

DougT writes:

Wouldn't an open-source ratings system run afoul of Goodhart's Law? Seems to me any open system is subject to being gamed. That's the problem with open indices like Russell and MSCI--they systematically underperform the S&P indices precisely because their open structure allows them to be arbed. An open-source rating system would have the same problem. Companies and pass-throughs would be structured to get just enough support to hit the bogey, and no more.

And what do you do with new products? S&P, Moody's and Fitch just guessed. That's what the open-source system would have to do as well.

Of course, you could just prohibit new products.

Peter H writes:

Milton,

Rating agencies have maintained for many years that ratings are a relative measure of credit default risk and not a measure of investment risk. The loss of value in mortgage securities and derivatives at the beginning of the great recession preceded, and was in excess of, the actual defaults on the underlying mortgages.

That doesn't mean the ratings agencies gave an accurate depiction of the risk of default, since their ratings did not at all accurately measure the default risk of the securities. The agencies, for example, allowed securities to get the benefit of being diversified even when the underlying notes (or CDSes if we're really getting absurd) were almost indistinguishable in credit risk characteristics and had giant correlations in downturns.

It was the loss in value of the collateralize mortgage securities and not defaults on the underlying mortgages that created the liquidity risk that caused the failure of Bear Stearns and the banking crisis.

Bear was insolvent, not just illiquid. And the ratings agencies did commit fraud. Even if it wasn't the only cause of the crisis, it's still criminal. Madoff didn't cause the financial crisis either, but he's in jail, as he should be.

The fact that banking regulators and the SEC expanded the use of the ratings beyond credit default to measure required capital levels is not the fault of the rating agencies.

I'm pretty sure that if an industry engages in a decades-long regulatory capture and lobbying scheme to extract giant rents via a regulatory system we can in part blame them for that regulatory system.

The fact that the models were not updated or corrected to reflect higher expected losses is irrelevant if the relative valuations of the credit risk of the debt securities would be unaffected. Credit ratings were never a measure of absolute risk. In recessions, all debt becomes riskier and more likely to default and not just mortgage debt. A higher rated security has an higher probability of default in a recession than in an economic boom period but its credit rating does not change.

Relative to what? Are you saying that the default rates on mortgage backed securities mirrored other AAA rated securities? Has corporate debt rated AAA in 2005 defaulted at comparable rates to date? AAA government debt? Both the absolute and relative risk of default on these securities was known to be higher than was portrayed by the agencies.

The misuse of a credit rating by an investor or government agency is not the fault of the rating agencies.

No, but fraud on the part of the agencies is. It is not misuse of the ratings to say that one AAA rated security should have a comparable risk of default to another AAA rated security. But the agencies, at the time they rated the securities in question, knew they had much higher risk of default than other AAA rated securities, and, under pressure from the people paying for the ratings and selling the securities, intentionally deceived the investing public.

I'm a free marketeer, but fraud is and should be a criminal act, and there is nothing wrong with the government going after people who defraud others.

Peter H, there are some highly questionable assertions in your analysis. If it's so obvious the ratings agencies committed fraud, why didn't Holder charge them with that?

He did something very different; he filed a civil lawsuit where 1. The burden of proof is much lower, and 2. S&P will probably do what Martha Stewart did; i.e., assess the probable costs of litigating the matter and try to settle for a figure less than that.

Further, you're ignoring that not all the MBS were rated AAA. There were three 'tranches'. The AAA were the 'last loser' tranches (and, in fact, performed much better than the others).

The 'first loss' tranches were higher risk, higher yield, and if the housing market had only declined by 20% would probably have absorbed all the losses. I.e., no financial crisis.

But, the decline was much greater than 20%, so the losses spread to the more highly rated tranches. Which was the design. There's a defense against a fraud charge.

Marc Joffe writes:

txslr

I address this argument in my Econ Journal Watch at http://www.econjwatch.org/828.

The short answer is that many fixed income assets are thinly traded by people with limited information, so the prices are nowhere near efficient. Just because information is available doesn't mean that all market participants will automatically assimilate it, let alone interpret it optimally.

I don't know about you, but I always look at Yelp before going to a new restaurant. I don't assume that bad restaurants have slashed their prices to achieve equilibrium.

Marc Joffe writes:

DougT

These are important concerns. To the extent that an open source solution has community support, it can evolve to address gaming. In implementing Dodd Frank, regulators are tempted to embed a fixed capital adequacy algorithm in regulations. This is worse than open source, because it can't evolve. Also, my open source tool is only a broad framework. The user has a lot of flexibility in specifying parameters.

With respect to new products, rating agencies have to develop new models to analyze them; otherwise they can't be rated. It is a simple matter to make these new models open source - just upload them to GitHub. Also, issuers of newfangled products always have the option of not purchasing ratings.

Peter H writes:

Patrick,

1. Holder should charge criminal fraud.

2. I'm aware that not all MBS were AAA, but the tranching structure was widely abused and produced extremely fragile securities which still got stamped with high ratings. E.g., a MBS squared comprising the lower tranches of mortgage backed securities compiled and then re-tranched might get to put 70% into a top tranche rated AAA. But it's extremely fragile to correlation in the housing market, and such securities defaulted at astounding rates in pre-crisis models when default rates rose by even small amounts.

If a company commits fraud 10% of the time, it's still criminal.

1. Holder should charge criminal fraud.

The fact that he didn't is telling. If he thought he had a good case he would have. Lacking that, he opted for the political maneuver.

Peter H writes:

Or he opted for the maneuver which protects his wall street benefactors while still looking good to the public. I have no love for the Obama administration, and I think regulatory capture is a very real problem. I see the decision not to pursue criminal charges to be an issue of corruption and regulatory capture, not an admission that a case can't be made. I don't think it necessarily speaks to the quality of the case, but rather the political importance of the defendants.

Even on the lower civil standard, to secure a judgment the government has to prove that in the balance of the facts, the alleged fraud did in fact likely take place.

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