American Bondage

The first amendment has been major legal defense that credit rating agencies have used to counter attempts by the federal and state governments to impose liability against such agencies for their failed ratings. Citizens United has pretty clearly established that corporations are persons entitled to full first amendment protection, and the various rating agencies have stated that their predictions (their “opinions”) about future trends are no less protectable than those of journalists, who also publish their predictions about the future without liability.

Various governmental agencies have argued that not only is speech imbued with liability in many circumstances (for example, you cannot yell “fire” in a crowded theater when there isn’t a fire, and if you use words to commitment fraud, likewise, there is liability), but given its commercial, money-making focus (versus journalistic expression), it falls under an area of commercial transactions where protecting free speech is not the fundamental social interest.

Well, on February 4^th, the federal government filed a huge civil fraud action against Standard & Poor’s – interestingly in a Los Angeles federal district court – that may wend its way over the years to the U.S. Supreme Court to determine this issue once and for all. Unless the credit rating agency settles to avoid the precedent, which is a distinct possibility. States are likely to join the litigation, and clearly the stock market is worried. McGraw Hill, S&P’s parent, saw its stock drop 14% at the filing, and other credit rating agencies saw significant drops in their share values as well.

“From September 2004 through October 2007, S. & P. ‘knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors’ in certain mortgage-related securities, according to the suit filed against the agency and its parent company, McGraw-Hill Companies. S.&P. also falsely represented that its ratings ‘were objective, independent, uninfluenced by any conflicts of interest,’ the suit said.” New York Times (Dealbook), February 4^th. It was all about the firm’s very positive ratings of what would become mega-toxic bundles of subprime mortgages, a practice that was paralleled by other credit-rating agencies as well.

Was S & P remotely aware of the reality behind their rating? “The executive at Standard & Poor’s was clear: ‘This market is a wildly spinning top which is going to end badly.’… That sober assessment of certain mortgage-related investments, delivered to colleagues in a confidential memo in December 2006, is now part of a trove of internal e-mails and documents that have come to light in [the] federal suit against S.& P… One comes from an S.& P. analyst in March 2007 borrowing from the Talking Headssong ‘Burning Down the House,’ creating new lyrics: ‘Subprime is boi-ling o-ver. Bringing down the house.’ S.& P. said prosecutors cherry-picked e-mails and that it would vigorously defend itself from ‘these unwarranted claims.’” NY Times, February 5^th. So far, Wall Street has escaped fairly unscathed by the economic collapse they helped cause, even benefiting by government bailouts. Will this time be different? And remember, this is a civil, not a criminal action.

The debt rating system has been and remains tragically flawed. When a corporation is about to create some form of debt instrument (commercial paper, bonds, etc.) and put it into the public marketplace, pricing structures and marketability depend entirely on a “neutral” evaluation of the risk. Buyers of such instruments need to know the risk of their investment, so these companies engage established credit rating agencies to review the proposed package and designate a rating that can be used to market those securities.

And there is the flaw. It is the company (the “issuer”) of the debt who picks the rating company that will rate it. The rating agency stands to make a pretty penny if they get the assignment, and it probably won’t get that assignment (and the big fat fee) if the issuer thinks that the agency would be too tough. After all, this is a competitive business and there are other ratings agencies waiting in the wings for the business.

What’s worse, on Wall Street, long-term relationships between the ratings agencies, the investment bankers who are helping to place the debt instruments and the ultimate issuers themselves have been in business for years and have long-standing personal relationships. We could have a government-administered system where the feds designate the agency or at least some form of blind pool where the issuer doesn’t get to pick the rating agency. But we don’t, because Wall Street likes it just the way it is.

You may notice how the concentration of wealth since the big economic collapse has moved heavily in favor of the one percenters as middle and lower class wage earners have seen their buying power erode. Most legislative and regulatory trends have favored big money over the average American… or, big contributors over those who don’t give much to political campaigns. Wouldn’t it be nice to see something – this case for example – begin extracting the kind of retribution that Wall Street has escaped to date?

I’m Peter Dekom, and even seeing this case filed is refreshing.