The weird, unsatisfying case against S&P
The government’s 119-page civil lawsuit against credit rating agency Standard & Poor’s for allegedly inflating the ratings it gave to residential mortgage-related securities, or RMBS, in the run-up to the crash has removed whatever lingering doubts (there weren’t many!) might have remained about just how problematic the ratings game is. But it also raises a question: Why, in cases of white-collar wrongdoing, is it often the cogs in the wheel that seem to pay the highest price?
Let’s stipulate that there are weird things about this case. To lower its burden of proof, the government is using a 1989 law that is supposed to protect taxpayers from frauds against federally insured financial institutions. The result, as Bloomberg columnist Jonathan Weil has pointed out, is that the government is claiming that some of the very banks — mainly Citigroup — that packaged the securities were also defrauded by the rating agencies.
Plausible? Well, yes, particularly for Citi, where the right hand often doesn’t know what the left hand is doing. And just because the banks fell for their own scam doesn’t mean it wasn’t a scam. But it’s still weird. It’s also weird that the government names some S&P executives but leaves others anonymous. And it’s weird that the government has sued S&P but not Moody’s Investors Service, which at least in outward appearance was equally culpable. (S&P, for its part, has stated that it is “simply false” that it compromised its analytical integrity, and that it has a “record of successfully defending these types of cases, with 41 cases dismissed outright or voluntarily withdrawn.”)
That said, you can’t read the case and feel good about the critical role that the rating agencies continue to play in our markets. At least according to the emails the government released, S&P’s claim that business considerations don’t affect its ratings is just flat-out false. Back in 2004, S&P circulated new criteria for rating structured securities. The agency’s “client value managers,” who were responsible for “managing the commercial relationship with clients” were to be “consulted for client information and feedback,” which would then be incorporated into the ratings. In a memo, an unnamed executive wrote, “Are you implying that we might actually reject or stifle ‘superior analytics’ for market considerations … does this mean we are to review our proposed criteria changes with investors, issuers and investment bankers?” He never got a response. In January 2005, S&P didn’t roll out a new model that would have made it harder to assign triple-A ratings to some CDOs (collateralized debt obligations). An analyst wrote that the model “could’ve been released months ago … if we didn’t have to massage the subprime and Alt A numbers to preserve market share.”
“Our old methodology gave us one single ‘best coin’ that is data driven,” wrote another S&P employee in 2007 as part of a discussion about how best to update models. “But if it turns out to be business unfriendly, we are stuck.” And so on.
Even worse, as the market began to melt down in 2007, S&P fully understood that it was helping the investment banks move bad securities off their books and onto the laps of investors — and took pride in the money it was making as a result. As S&P Managing Director David Tesher wrote in a March 2007 email, “Many dealers accelerated the timing of CDO’s that were in the pipeline in order to mitigate/manage their respective warehouse exposure.” A few months later another managing director wrote, “Because of the effect of the subprime RMBS situation, in March we experienced the highest monthly deal volume ever, doubling the total from the previous two months.” (Investors could and should have done their own due diligence. They might have been more inclined to do so, however, had S&P informed them that the investment bankers were using them as garbage disposals.)
There is something more dangerous than sheer venality, though, and that’s venality mixed with incompetence ‑ which S&P had in spades, according to the complaint. Although the agency told investors it was doing “surveillance”—monitoring existing mortgage-backed securities to see how they performed—the analysts who rated CDOs, which of course were composed in large part of RMBS, simply weren’t told whether the surveillance team was considering a downgrade—sort of akin to a chef not being informed that the ingredients have gone bad. As a result, those analysts would simply accept the RMBS rating at face value, thereby inflating the CDO rating. Even after S&P had decided that it would do large scale downgrades of non-prime RMBS, no one communicated that to the CDO team, which continued to confirm ratings on billions of dollars of CDOs.
In July 2007, an S&P analyst wrote to an investment banker: “The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.” The investment banker wrote back: “This might shake out a completely different way of doing biz in the industry. I mean come on, we pay you to rate our deals, and the better the rating the more money we make?!?! Whats [sic] up with that? How are you possibly supposed to be impartial????” Yes, Virginia, the model is broken.
But what’s also apparent from the complaint is that while S&P’s piece of the wheel was critical, S&P’s share of the loot was tiny, at least relatively speaking. The government says from September 2004 through October 2007, S&P slapped credit ratings on over $2.8 trillion of residential mortgage-backed securities and an additional $1.2 trillion of CDOs fashioned out of those RMBS. Without a triple-A rating, those securities couldn’t have been sold. But S&P got just a sliver of what the designers of the wheel received. According to the government, S&P charged a fee of $150,000 for each non-prime RMBS it rated, and up to $500,000 for each CDO. In contrast, one knowledgeable source told me that on some CDOs, the fees and expenses chewed up 40 percent to 50 percent of the cash flow; according to Forbes, banks typically charged up to $8 million to underwrite an RMBS securitization and as much as $10 million for a CDO. Another way to think about this is that the entire fee S&P earned for rating a CDO was less than the average 2006 compensation — about $623,418, according to the New York Times — for a Goldman Sachs employee.
The New York Times and others have reported that the government is seeking some $5 billion from S&P, which is more than five times what it made in 2011. Some say this could put S&P’s parent company, McGraw-Hill, out of business, or at least prompt a reorganization; its stock has lost nearly a quarter of its value since the lawsuit was filed. Investment banks, by contrast, have paid some fines, but nothing life-threatening. As bad as S&P’s behavior allegedly was, it’s got nothing on the banks. Sure, S&P told investors it was doing surveillance of its ratings. Well, the investment banks promised investors they were doing due diligence on the mortgages they packaged — but when the news was bad, the bankers ignored it. Sure, S&P masqueraded as investors’ best friend. Well, that’s the definition of a salesperson at a bank. And neither S&P nor the bankers had a fiduciary duty to investors.
Maybe cases stemming from the financial crisis really are so difficult for the government to make that the only option is to use a random law in order to get the cog in the wheel. Maybe it’s better to punish the cog than to punish no one. But let’s not pretend it’s fair. And if the government’s case doesn’t result in fundamental changes to the ratings game, then no one has won.
PHOTO: A view shows the Standard & Poor’s building in New York’s financial district February 5, 2013. REUTERS/Brendan McDermid