COLUMN-Taking on the rating agencies
By Charles R. Morris
NEW YORK Feb 5 (Reuters) - The credit rating agency, Standard & Poors, announced Monday that it was the target of a civil lawsuit by the Justice Department for its actions in rating the complex securities that played a major role in the 2008-2009 financial collapse. The company also said that it had not been apprised of the details. It is interesting that the other two major rating agencies, Moody's and Fitch made no announcements.
There is much that all the agencies should worry about. What is publicly known - and it is a great deal - was laid out in the two-year Senate investigation led by Senator Carl Levin (D-Mich.), which ended with the release of a final report in spring, 2011.
The committee staff laid out a formidable case. As early as 2004 and 2005, and increasingly by 2006, the email chatter among the rating agency staffs suggested they were expecting a crisis. One email said: "This is frightening. It wreaks of greed, unregulated brokers and 'not so prudent' lenders." Staff analysts asked why the regulatory agencies hadn't "come down harder on these guys." One wrote worriedly about the possibility of "another banking crisis."
One damning sequence occurred in spring, 2007. Early that year, it became clear that the subprime mortgage market was in serious trouble. Two major subprime issuers failed in December 2006, and in the first quarter of the new year, another 20 failed, including the giant New Century. This was also the period, as we now know, that Goldman Sachs embarked on an aggressive internal clearing of its inventory, or "The Big Short" as it was called, which was largely accomplished by selling to greater fools.
But for the most part, Wall Street and the credit agencies shrugged off the worries and carried on with business as usual. The agencies issued triple-A ratings even on booby traps like the security that Goldman devised for the hedge fund manager John Paulson, so he would have a $1 billion plus security that he could bet against with confidence in its shakiness.
Yet, mysteriously, the tempo of work at the credit agencies changed radically in July. In the first week, S&P quadrupled its output of ratings, and Moody's doubled theirs. The volumes of issuances had not been increasing, so this step up is output in extraordinary. These were extremely complex securities, with intricate shifts in the credit-worthiness of one part of the structure based on the prices of another. Often, the value shifts were non-linear. Instead of a decline that followed a reasonable curve, for example, there could be leaps or plunges in value that appeared out of proportion to the triggering event. S&P analysts had complained all year about their stretched staffing, yet that week they pushed out 300 new ratings a day.
Then in the very next week of July, both agencies suddenly switched to down-grading - and doing it violently. Some 900 instruments were downgraded by one or both agencies, usually by several notches, and often driving AAA-rated securities all the way down to junk. Hundreds more securities were placed on credit watch.
No one had ever seen anything like it. The downgrading continued, more as a series of eruptions rather than a smooth curve. One set of coordinated downgrade actions in early 2008 by S&P involved a half-trillion dollars of securities.
When senior ratings agency executives were later interviewed by the Senate committee, they professed themselves to be clueless. He was told the downgrades were coming, one said, but he wasn't told why - and presumably didn't think to ask, even about an event that could destroy their core business.
Though it may be un-provable, it's obvious what happened. Aware that their ratings were growing more and more preposterous, the agencies finally adjusted their standards and set a date to start using them. Then with utter cynicism, they pushed through as much work in process as they could before the change took effect, so as not to lose their fees.
In other words they used ratings criteria that they knew were wrong. And it also looks as if they were colluding at the same time.
The credit agencies, it was always clear, were the pawns of the banks, which accounted for the lion's share of their revenue. The agencies' stock prices were soaring along with their fees, and managers and executives were getting rich. It's just another example of how easily strict codes of ethics crumble at the scent of money.
The executives look like they topped off their spinelessness with cravenness. When they were called to account by investigators, they cravenly sheltered under the pretense that they were just another species of journalist, making "free speech" comments, with no intent to offer guidance to investors. A civil action is a de minimis response. But at least it will put their shameful behavior back in the spotlight.
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