Before we begin, let's take a moment to ponder the absurdity of a system in which...
a) for-profit corporations are allowed to call themselves "agencies";
b) the government -- that is, us -- gives these for-profit companies given trillion-dollar influence over the financial system; and
c) these "agencies" are paid by the very financial institutions whose work they're expected to review objectively -- institutions who will take their business elsewhere if their products aren't rated highly.
We gave these "agencies" all this power, along with a huge financial incentive to rate garbage as if it were roses. Then we, in the form of government regulators, looked the other way. And now we're shocked -- shocked! -- that these for-profit companies were behaving ... well, like for-profit companies.
There's an extremely strong case for fraud in the government's new lawsuit against Standard & Poor's. The suit says S&P lied to the SEC in order to be certified as a credit rating agency, and that it lied to investors about the objectivity and thoroughness of its reviews. It also alleges that S&P knew that some of the mortgage-backed securities it rated "AAA" were, in fact, lousy investments, and gave them that rating anyway to keep the bank's business.
Body of Evidence
There's a lot of compelling evidence in the lawsuit. Much of it is taken from the Senate's Permanent Subcommittee on Investigations, chaired by Sen. Carl Levin, which we reviewed in detail in "The Rating Game" and "Poor Standards."
One email exchange shows that an analyst was pressured by S&P to improve a rating for their "customer," and when the analyst offered a somewhat higher score he wrote, "I don't think that will be enough to satisfy them." When another analyst asked to look at some files for a review, which is the standard way of doing things, he was told that his request was "TOTALLY UNREASONABLE!"
S&P isn't just ethically challenged. It's also lousy at what it does. When it downgraded US debt in 2011, for example, the Treasury Department found a $2 trillion error in S&P's calculations. S&P simply deleted the error from their report, then wrote up a completely different rational for their downgrade -- one that relied on unmeasurable and intangible considerations. To the trained eye that suggests they'd already picked a number and they were now making up reasons to justify it.
A billion here or there is one thing. But a trillion? That's just plain sloppy. As long as that kind of workmanship is driving our financial system, this lawsuit is important. Here are five takeaways from this action:
1. Ratings agencies are very important -- and very broken.
Ratings agencies are given enormous responsibility and enormous power. Some investments are required by law to invest in only "AAA" financial products. Others, like many pension funds, have made the decision to stick to these (supposedly) safe investments exclusively.
S&P and other ratings agencies took banks' money in return for rating their mortgage-backed securities "AAA." Many of those securities were a form of organized fraud that was perpetrated on investors. These securities were such an easy way to earn money that they drove the housing bubble: Banks didn't want to know if a borrower was a bad risk, because they could just bundle the loan with a lot of other equally doubtful ones and sell them all off to unwary investors.
That's a guaranteed way to make money -- for a while -- as long as the rating agencies were guaranteed to give these worthless investments a "AAA" rating. And they were. That places the rating agencies at the heart of the financial crisis, the recession, and all the loss that resulted from those events.
That's as important, and as broken, as it gets.