Louise Story at the New York Times reports that the SEC is looking into whether it has grounds to file suit against the ratings agency Standard & Poor’s for publishing higher ratings on bonds than the analysts had recommended. The article reports that the agency has found instances where executives overrode analyst judgement to award higher ratings on mortgage bonds that were later downgraded and produced investor losses. The piece indicates that the SEC has found instances of this sort of misconduct; the question seems to be whether it took place often enough to make a case.
From the Obama administration’s standpoint, it must seems rather unfortunate that the SEC has decided to go after S&P just as Matt Taibbi has called attention to the fact that the agency has organized its affairs so as to help it avoid seeing all but the most egregious misconduct. Readers will point out that any case would be politically motivated, but those who live by the sword should be prepared to die by the sword. S&P’s downgrade of the US bears all the hallmarks of reflecting the agenda of McGraw Hill chairman and CEO Terry McGraw. Among other things, he is head of the Business Roundtable, which has having Social Security privatized as one of its policy aims. S&P was completely silent when the deficit widening Bush tax cut extensions were approved at the end of last year. Jane Hamsher has chronicled in detail how S&P swung into action on the deficit attack front when efforts to increase regulation of its activities ratcheted up. So having chosen to wage a political war, S&P should not be surprised to encounter this sort of pushback.
Ironically, the downgrade may provide the impetus to finish a Dodd Frank task that was left incomplete: that of reducing the importance of ratings in the investment process. As the Times story notes:
A successful case or settlement against a giant like S.& P. could accelerate the shift away from the traditional ratings system. The financial reform overhaul known as Dodd-Frank sought to decrease the emphasis on ratings in the way banks and mutual funds invest their assets. But bank regulators have been slow to spell out how that would work. A government case that showed problems beyond ineptitude might spur greater reforms, financial historians said.
“I think it would have a major impact if there was a successful fraud case that would suggest there would be momentum for legislation that would force them to change their business model,” said Richard Sylla, a professor at New York University’s Stern School of Business who has studied the history of ratings firms.
In particular, Professor Sylla said that the ratings agencies could be forced to stop making their money off the entities they rate and instead charge investors who use the ratings. The current business model, critics say, is riddled with conflicts of interest, since ratings agencies might make their grades more positive to please their customers.
Professor Sylla must be aware of the fact that investors were the ones who once paid to find out the rating of various securities. What led the ratings agencies to abandon this model? The Xerox machine. It made it easy for investors to pass on rating agency reports cheaply, depriving them of revenue. Now there are investment newsletters that face the same problem, and go to some length to protect their intellectual property, but they are also much smaller businesses than the ratings agencies. In addition, with ratings still enshrined in various regulations and investment guidelines, it is the part that is valued most – the rating itself, rather the commentary – is also the easiest to disseminate.
A friend who is fond of intrigue has said, ‘If you challenge the king, you must kill him.” S&P may learn the consequences of failing to heed his advice.
Update: 1;30 AM: Reader MBS Guy pointed out that it would have been trivial to make this probe look more even-handed, since Moody’s has engaged in similar conduct:
On the other hand, the SEC already has plenty of ammunition for a similar investigation of Moody’s. In the SEC’s request for comments on the proposed new rules for rating agencies (NRSROs), a disgruntled former Moody’s employee submitted a long, detailed account of how senior management at Moody’s improperly influenced the ratings process, intimidated and harassed employees and promoted for MBS and CDO managing directors because to fire them would be an admission of guilt. Not only that, senior management at Moody’s, which was largely intact even after their obvious failures before the crisis, continued to cover up their failures and harass employees as recently as last year (and probably beyond).
The report can be found here.
It’s a little disjointed and long winded, but it is a pretty devastating report on how bad the rating practices and management were at Moody’s and, by implication, how little was done about it.
I had thought it was pretty weird to hear the SEC claim, as they do in the article, that it was having trouble finding ex S&P employees who were willing to testify against the ratings agency. MBS Guy agreed:
This is pretty silly. I know of a dozen former employees of Moody’s and S&P who have openly complained about these issues and a number of them have already spoken to various regulators. In fact, if the SEC wanted ammunition for these types of claims, they need only go to their own website, where a former Moody’s employee named William Harrington has posted a long report on Moody’s in response to the SEC’s request for comments on the proposed regulations for NRSROs.
So much for the SEC’s ability to do research….