Secret Agents

One of the weakest links in the American financial system has to be the credibility of the relevant credit ratings agencies, companies like Standard and Poor’s, Fitch and Moody’s. Effectively, their job is to rate various debt instruments as to level of market risk, assigning a ratings designation, which impacts the value and the price of the relevant debt. The cost of borrowing goes up and the value of the issuing debtor and the resultant debt go down as the ratings suggest increasing risk. Entire nations and major banks are often rated by these agencies, and the borrowing rate of an entire nation, including the United States, can be raised when its debt rating is lowered.

On the commercial side of debt, debtors and their brokers often will present a prospective debt offering that they would like to sell in the public or private marketplace to such a ratings agency in order to secure a rating, a necessity in order to set pricing. Buyers usually rely very heavily on the actual rating issued in making a decision whether or not to buy or invest. Here’s where the problem starts. The credit rating agencies get selected and paid by the entity issuing the debt… not by the buyers. If they are judged as being too hard on debt issuers, the entity seeking the rating simply moves on to another rating agency. Over the years, the biggest financial institutions have established such a heavy flow of deals and demands on the ratings agencies. Do you think that huge customers with repeat business over many years just might get more favorable treatment of their debt offerings than might be justified?

When challenged on their ratings, these agencies have taken the position – successfully so far – that their ratings are simply opinions which are protected free speech under the First Amendment. Really? So if I make statements that result in criminal fraud, I cannot be prosecuted because my fraudulent words were expressions protected under the First Amendment? Yeah, well, times may just be changing for the ratings agencies and their obvious and horrific conflict of interest in getting paid to issue their “opinion” by the debtor.

“The case, filed in [federal district court] 2008 by a group of 15 institutional investors against Morgan Stanley and [Moody’s Investors Service and Standard & Poor’s], involves a British-based debt issuer called Cheyne Finance. Cheyne was a structured investment vehicle, created in 2005, that raised $3.4 billion in short-term debt from investors. The company was meant to profit by purchasing longer-term obligations that generated more in interest than the company paid to its lenders.

“But Cheyne collapsed in August 2007 under a load of troubled mortgage securities. The institutions that bought almost $1 billion of its debt, including the Abu Dhabi Commercial Bank, the fund manager SEI Investments and the Public School Employees’ Retirement System of Pennsylvania, lost much or all of their money… The investors have argued that their losses resulted from fraud and negligence by Morgan Stanley, which marketed the deal, and the ratings agencies that graded it highly. They contend that the agencies knew the data and assumptions used to assess Cheyne’s obligations did not support the ratings, which did not reflect the risks in the portfolio.” New York Times, July 2^nd.

Despite Moody’s argument for protection under the First Amendment and their claim that “Our ratings are fully independent and based on robust and objective analytical criteria,” the court looked at evidence that seemed to point in a different direction and ruled that such constitutional protection might not apply in this case. “…Shira A. Scheindlin, the federal judge overseeing the matter, ruled in September 2009 that [the First Amendment] did not apply because the Cheyne deal was a private offering whose ratings were distributed to a small group of investors and not the public at large. Judge Scheindlin agreed with the plaintiffs, who argued that the ratings were not opinions but were misrepresentations that were possibly a result of fraud or negligence.

“‘The disclaimers in the Information Memoranda that ‘a credit rating represents a rating agency’s opinion regarding credit quality and is not a guarantee of performance or a recommendation to buy, sell or hold any securities,’ are unavailing and insufficient to protect the rating agencies from liability for promulgating misleading ratings,’ Judge Scheindlin ruled. .. For example, when the primary analyst at S.& P. notified Morgan Stanley that some of the Cheyne securities would most likely receive a BBB rating, not the A grade that the firm had wanted, the agency received a blistering e-mail from a Morgan Stanley executive. S.& P. subsequently raised the grade to A.” NY Times. Is this a new judicial trend? Will it be sustained in the appellate courts?

The rather consistent awarding by these agencies of significantly high ratings to subprime mortgage bundles of debt created a market in these instruments that accelerated the creation of additional such structures to service client demand for relatively high yield and seemingly low risk aggregation of debt. This pattern pumped massive amount of uncollateralized debt into our economy and was one of the major driving forces in the overall economic collapse.

Yet despite this destructive result, very little has been done in the world of containing the ratings agencies. Issuers still pick their ratings agencies and avoid those agencies that they believe will not produce the required result. Even the simplest solutions, like requiring debtors-seeking-ratings to address such needs in a blind pool, where they cannot pick the ratings agency (it is simply randomly assigned), have been so strongly opposed by Wall Street – fearing that objective ratings might limit their ability to sell debt into the market – that no effective regulation has been implemented. Wall Street’s lobbying efforts have just stonewalled any attempt to reign in these excesses.

The problem with this seeming lack of objectivity is that the evils that gave rise to the last big market collapse appear still to be largely still in existence. The U.S. Dodd-Frank legislation didn’t seem to make much of a difference, and we are still seeing continuing billion dollar mistakes in our biggest financial institutions, despite their own pledges to fix their machines by self-regulation. The $2 billion losses (which apparently could grow to as much as $9 billion) at JP Morgan Chase from bungled trading or the hefty fines placed on Barclay’s for their purported manipulation of interbank borrowing rates in Europe are the latest in a string of financial missteps that tell us all is still far from under control in our most important bastions of potential stability in a roiling sea of global debt problems. “Too big to fail” still gives me a queasy feeling, and the thought that the lack of fair and consistent regulation could easily re-stage the same underlying causes for the last collapse makes me grateful I am in the later stages of life. That there are masses of people who want even less regulation, in light of these clear and present dangers of financial ships veering off course, still seems incredible to me. Trusting the financial institutions to do the right thing is an idea whose time is long past.

I’m Peter Dekom, and Philosopher George Santayana admonition that “Those who cannot remember the past are condemned to repeat it” rings in my ears.