This week in encouraging news, we learn that the Securities and Exchange Commission may finally be pursuing one of the prime enablers of the financial crisis -- the ratings companies. Previously, it was reported that disclosure violations were on the SEC’s radar, but truth be told, those are minor offenses.
The SEC’s Office of Credit Ratings, a division whose sole purpose is essentially to oversee Moody’s and Standard & Poor's, seems to be stirring. The Wall Street Journal reported that the “government's top credit-rating watchdog has kept a low profile since taking the job two years ago to help prevent another financial crisis. That may be about to change…” Multiple cases have reportedly been referred to the SEC's enforcement division, and new regulations are due.
And a welcome change it would be. Of all the players that helped cause the financial crisis, the ratings companies have gotten off scot-free. Banks have had massive fines while many mortgage and derivative underwriters have had their garbage securities put back to them at great cost. Since 2008, there have been 388 mortgage companies that have gone bankrupt. All of that junk paper found its way into AAA-rated securitized products and derivatives. The penalty for Moody’s and S&P has been essentially nil. Fear of so-called reputational damage -- the theory that concerns about their good name keeps companies in line -- is the latest economic nonsense to be thoroughly debunked by events.
It's hard to overstate the role of the raters in contributing to the financial crisis. Nobel Prize winner and Columbia economics professor Joseph Stiglitz does as good a job as anybody:
I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.
As we have since learned, the raters weren't, as they claimed, passive participants that just happened to get bamboozled by underwriters, thereby underestimating any likelihood of default. Instead, they engaged in a form of pay-for-play, selling their ratings to the highest bidder. They placed their highest AAA rating on all sorts of junk securitized mortgages. And, they were active collaborators in the underwriting of this paper.
I would suggest the SEC focus on the changed business model of the ratings companies. In the 2000s, they charged the underwriters rather than investors for the ratings. Any company is free to do whatever it wants in terms of its business model. But the major raters are not just any business; they are Nationally Recognized Statistical Rating Organizations, in essence a government stamp of approval. The SEC, in turn, lets other companies rely on the raters credit evaluations for regulatory purposes.
As one S&P analyst told another who dared to question the validity of the ratings process: “We rate every deal. It could be structured by cows and we would rate it.”
This wasn't a function of “honest opinion” from someone whose analysis was simply wrong -- it was about knowing, willful fraud for pay. Big money. Revenue at the three biggest ratings firms doubled between 2002 and 2007 to $6 billion. According to MarketWatch, Moody's Corp. had the highest profit margin of any company in the Standard & Poor's 500 Index for five years running.
Full disclosure, I have had my own run-ins with S&P parent company McGraw Hill Financial Inc. It was the original publisher of my book ``Bailout Nation,'' but balked when the submitted manuscript contained passages that were critical of its S&P credit ratings division, as well as Moody’s. The full sordid tale is here.
It was -- and remains -- impossible to write about the financial crisis without laying substantial blame at the feet of the credit rating companies. Now, more than five years after the crisis, there remains a sliver of hope that two of the worst actors might be held to account for their role in the worst banking crisis since the Great Depression. It is long past due.
To contact the author of this article: Barry Ritholtz at firstname.lastname@example.org.
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