Washington vs. S&P: Just the tip of the iceberg?

When Washington sued Standard & Poor’s this week for falsifying ratings on mortgage-backed securities, I was not the least bit surprised, and I don’t think you were either.

I have been writing you about conflicts of interest at Wall Street ratings agencies for over twenty years.

I submitted proposals for reform to Congress, the SEC and the rating agencies themselves.

And I’ve virtually stood on the rooftops to shout my warnings about dire consequences of their shenanigans.

The Justice Department claims S&P refused to warn investors that the housing market was collapsing in 2006 because it would be bad for business. Could this serve as a template against Fitch and Moody’s?

What IS surprising about this situation, however, are some of the strange defenses that S&P has offered.

“We weren’t the only ones,” they insist.

True, all of the Big Three Wall Street rating agencies — S&P, Moody’s and Fitch — published very similar high ratings on the same flawed securities. But as I’ll explain in a moment, that’s a big part of the problem.

“No one knew,” they say. “We gave them our top ratings based on the best information we had.”

Baloney! The crash in the mortgage market was already well under way — and widely reported — long before the Big Three rating agencies began seriously downgrading the securities. Anyone tracking this market knew, or should have known, exactly what was going on.

But the underlying causes — and dire consequences — go far beyond this one scandalous incident. And that’s the main point that nearly everyone in this case, including both plaintiffs and defendants, seems to be missing.

So let’s cut to the chase and go straight to the hard realities:

First, the entire business model of the Big Three ratings agencies is conflicted.

The issuers (the rated companies) are empowered to decide whether to be rated or not.

They can appeal a rating change before it’s published.

They are often given enough insight into the ratings formulas to manipulate their own financial data and game the system.

Most important, they are regularly required to pay the Big Three big fees for the ratings.

In sum, the ratings are bought and paid for by the very companies being rated; and those companies are often empowered to unduly influence the outcome at multiple stages in the process.

You wouldn’t trust the rating of a five-star hotel if you suspected the owners paid big bucks to get it. Yet, millions of Americans are routinely entrusting their hard-earned savings to those who do precisely that.

Second, this conflicted business model is the basis not only for the mortgage-backed securities at the center of Washington’s lawsuit, but also for the Big Three’s ratings on tens of thousands of corporate bonds, municipal bonds and even government bonds. And it’s also at the heart of big risks and losses in insurance policies or even bank accounts.

Third, the fiasco of the mortgage-backed securities was especially egregious because the Big Three ratings agencies also hired themselves out as consultants to help the issuers structure the securities in the first place.

But as I thoroughly documented here just last November, this certainly wasn’t the first time investors lost fortunes due to the Big Three’s deeply conflicted business model. For example …

In a landmark 1994 study of rating agencies, the Government Accountability Office (GAO) concluded that S&P, Moody’s, A.M. Best, and Duff & Phelps (now Fitch) failed to downgrade large insurance companies that subsequently failed — until it was too late for most policyholders.

S&Pdid not issue a “vulnerable” rating for one of the biggest failed companies, Fidelity Banker’s Life, until six days before the failure, and it did not issue a vulnerable rating for another, Monarch Life, until 351 days after the failure.

Moreover, evidence in a court case revealed that, in addition to its standard fees, S&P may have collected an extra $1 million in order to guarantee a triple-A rating to Executive Life, a big junk bond investor that later failed.

Or fast forward to the Enron failure of 2001. The New York Times reported that the Big Three rating agencies saw clear signs of Enron’s deteriorating finances in May 2001, but did little to warn investors until at least five months later. (See “Credit Agencies Waited Months To Voice Doubt About Enron.”)

The Big Three claimed they had no way of knowing about the impending failure of Enron because it was largely caused by hidden, Enron-related trusts that were taking most of the big risks.

But the Big Three were also rating those same trusts in the first place. So this excuse was obviously full of holes.

Sound familiar? It should: Today S&P claims ignorance despite the fact that Big Three ratings agencies like S&P played a critical role in creating the securities in the first place.

So they obviously have had a more intimate knowledge of them — and their marketplace — than the public. And as I said, even the public knew about the collapse in that marketplace.

Fourth, let’s not forget that, not long before Washington took this action against S&P for its ratings on mortgage-backed securities, it severely scolded — even threatened — S&P for its downgrade of U.S. government debt.

In other words, the government that’s prosecuting S&P for alleged dishonest ratings is the same government that dragged S&P through the coals because of a courageous step S&P took toward honest ratings.

Fifth, the government has taken no substantive action to encourage a change in the Big Three’s conflicted business model.

Now, regardless of what you or I may think about that model, each company has a right to decide how to run its own business. So I don’t advocate more government regulation of the ratings business — let alone direct interference.

But by the same token, the government should NOT be in the business of endorsing and supporting that business model. Unfortunately, however, that’s precisely what the government does — by awarding the Big Three rating agencies the official status of Nationally Recognized Statistical Ratings Organization (NRSRO), giving them special privileges and advantages in the marketplace.

Sixth, with the government’s tacit endorsement of the Big Three’s conflicted business model — and with no steps taken to change it — the housing and mortgage disaster of recent years is not going to be the last financial disaster to strike investors.

Unfortunately, there’s every reason to believe it WILL happen again.

And what’s most ironic — win, lose or draw — there’s nothing in Washington’s latest action against S&P that will change it either.

What’s the most likely bond and ratings fiasco ahead?

It’s the same one we have been warning you about repeatedly in many of these Money and Markets issues: U.S. Treasury bonds.

Their top-notch ratings (even after S&P’s downgrade) are an anachronism.

And even though an outright default by the U.S. government is unlikely, the probability of big losses by bond investors is growing by the day — due to market price declines, a depreciation in the dollar, or both.

Don’t be fooled by the high ratings from the Big Three on your bonds. Also beware of marketing by “stock analysts” that’s financed by the companies they are covering — a topic I will cover in the near future.

Instead, always seek independent evaluations of your investments — those that are free of any conflicts of interest.

Good luck and God bless!

Martin

 

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