Credit Rating Investigation

Long time readers know that this has been an issue of interest to me, because I am simply flabbergasted that no one has gone after the Credit Ratings agencies after the Wall Street meltdown the way they went after Arthur Anderesen following Enron. As far as I am concerned, the Ratings Agencies were willing accomplices:

California Attorney General Edmund G. Brown Jr. began an investigation into three major U.S. credit-rating companies and their role in the financial crisis, in part to determine whether the firms violated California law.

The attorney general’s office on Thursday issued subpoenas to McGraw-Hill Cos.’ Standard & Poor’s Ratings Services, Moody’s Corp.’s Moody’s Investors Service and Fimalac SA’s Fitch Ratings, ordering them to provide information on their ratings processes by Oct. 19.

The agencies “put their seal of approval on high-risk mortgage-backed securities, recklessly giving stellar ratings to shaky assets that proved toxic to the entire financial system,” Mr. Brown said.

The move is the latest probe into how the ratings companies rated billions of dollars in mortgage-related securities, many of them underpinned by subprime loans.

This is excellent news. In other news, it looks like the Goldman boys finally pissed off enough people. Not sure if the case in which their proprietary code was stolen was the final clue that regulators need, but it looks like they are making a move (albeit a small first step):

It is an obscure art of Wall Street, a technique that gives a scattering of traders an edge over everyone else — and the Securities and Exchange Commission wants to stamp it out.

The S.E.C. on Thursday proposed banning what are known as flash orders, which use powerful computers to glimpse at investors’ orders. The practice is often associated with a controversial corner of finance called high-frequency trading, which has grown, largely hidden from view, into a potent force in the markets.

The proposed ban was announced on the same day that the S.E.C. put forward new rules for credit ratings agencies, which were widely criticized for their role in the financial crisis. Together, the moves telegraphed a tougher line from the commission after a series of prominent missteps, including its failure to spot the Ponzi scheme orchestrated by Bernard L. Madoff.

Critics say flash orders favor sophisticated, fast-moving traders at the expense of slower market participants. Using lightning-quick computers, high-frequency traders often issue and then cancel orders almost simultaneously and get an early peek at how others are trading.

I’m hard-pressed to figure out how flash trading was EVER legal. It makes absolutely no sense to me. As I understand it, this is fundamentally no different from one player at a poker table being able to look at everyone’s cards before every hand. It really is kind of insane.






62 replies
  1. 1
    Napoleon says:

    JC said: “I’m hard-pressed to figure out how flash trading was EVER legal. It makes absolutely no sense to me.”

    From all the facts I have seen to date it appears to me to be blatantly illegal trading on inside information, albeit inside info for only a millionth of a second, but that is all they need for their computers to act on it.

  2. 2
    Zifnab says:

    I’m hard-pressed to figure out how flash trading was EVER legal.

    I was going to say, it seems to practically be the definition of insider trading. Not to mention violating a host of privacy laws. I mean, just imagine a company suggesting it gets to look through all your stock purchases every day and selling the information to outside agents? The guys running this service should be looking at freak’n prison time.

  3. 3
    Comrade Dread says:

    It was legal because companies with a lot of money will hire very bright people to try and take advantage of any system that gets set up. They also avail themselves of good lawyers to examine the law, find loopholes, and take advantage of them.

    Truly this proves that there is too much government regulation of the financial industry and the only way to stop people from taking advantage of loopholes in the law is to get rid of the law altogether. /sarcasm

  4. 4
    Just Some Fuckhead says:

    California Attorney General Edmund G. Brown Jr. began an investigation into three major U.S. credit-rating companies..

    That’s Jerry Brown, BTW. He gets around.

  5. 5
    Bootlegger says:

    The problem is the law keeping up with technology. It wasn’t illegal because no one had encountered the problems associated with it yet.
    I’m no fan of the Drug War, but the Congress reacted to “designer” drug synthesis by giving the regulatory body, the DEA (again, not a big fan), the power to outlaw new compounds as they appeared. Maybe its time the SEC had the same power. Also, it would be good if the DEA wasn’t run by drug dealers….er, I mean the SEC wasn’t run by finance people.

  6. 6
    joes527 says:

    @Just Some Fuckhead:

    That’s Jerry Brown, BTW. He gets around.

    And how

  7. 7
    linda says:

    I’m hard-pressed to figure out how flash trading was EVER legal. It makes absolutely no sense to me.”

    exactly. how is an advance peak at information thru computers any different from a desk jockey dropping a dime to a pal after reading some insider scoop.

  8. 8
    Napoleon says:

    @Comrade Dread:

    CD said: “Truly this proves that there is too much government regulation of the financial industry and the only way to stop people from taking advantage of loopholes in the law is to get rid of the law altogether. /sarcasm”

    You think you are joking but that basically was exactly the case Bush made for tax cuts at one point, that the rich would just cheat so change the law.

  9. 9
    noncarborundum says:

    @Comrade Dread:

    the only way to stop people from taking advantage of loopholes in the law is to get rid of the law altogether

    Or people. Unfortunately that solution has at least one serious downside.

  10. 10
    PG says:

    The difficulty in going after the credit rating agencies is that they have in the past successfully argued that they have a First Amendment right to state their opinion (which, theoretically, is what a credit rating is) without fear of prosecution. Floyd Abrams has been hired to defend CRAs not because he’s an awesome securities lawyer, but because of his First Amendment expertise.

    Where this argument falls apart is when the CRA no longer has the arms-length relationship to the security-creator whose security it is rating that, say, a newspaper has to a restaurant it is reviewing. At the point that the CRA is working with the creator of the security to adjust it here and there in order to bump up its rating, the CRA is no longer merely giving a disinterested opinion; it is aiding and abetting any dishonesty that the creator of the security is guilty of.

    See, e.g., In re Fitch, 330 F.3d 104 (2d Cir. 2003) (highlighting two factors it considered important in determining whether a rating agency should be designated as a member of the press, one of which was the agency’s role in the transaction, to determine whether “[the agency’s communications] reveal a level of involvement with the client’s transactions that is not typical of the relationship between a journalist and the activities upon which the journalist reports.”)

  11. 11
    me says:

    The attorney general’s office on Thursday issued subpoenas to McGraw-Hill Cos.’ Standard & Poor’s Ratings Services, Moody’s Corp.’s Moody’s Investors Service and Fimalac SA’s Fitch Ratings, ordering them to provide information on their ratings processes by Oct. 19.

    It’s the suede-denim secret police!

  12. 12
    SGEW says:

    The Efficient Capital Market Hypothesis strikes again!

  13. 13
    Napoleon says:

    @linda:

    It is no different, it just happens at a much faster sped.

    Arguing that it is not insider trading because you are using computers would be like arguing that you really didn’t murder someone because you did it with a laser beam instead of a knife or musket, which were the murder weapons of choice back in the day the murder statute went on the books in your state.

  14. 14

    Call this flash trading what it really is: frontrunning. In other words they look at all the trades just prior to them being made and make trades accordingly, then they execute the trades of everyone else. Nice work if you can get it. I suspect they make just enough money off of this nefarious practice to pay all those sky high bonuses we keep reading about. But this would be a good start. However, you still have to go through a public opinion period then a second vote so it isn’t written in stone yet. Beware the evil fuckers lurking in the shadows they are a powerful force and the SEC is trying to take their lunch money.

  15. 15
    Original Lee says:

    John, since at least late May, various agencies and Congress have been looking into credit rating agencies. These inquiries are part of a queue of investigations that are being tackled in order of perceived impact, as far as I can tell, so now that the CDS, Countrywide, and Merrill Lynch stuff is well in hand, they can turn their attention to the CRAs. I believe the appraisers are next.

  16. 16
    Chuck says:

    It wasn’t illegal because it made big companies lots of money and we all know that is never bad and why do you hate america?

  17. 17
    Zifnab says:

    @noncarborundum:

    Or people. Unfortunately that solution has at least one serious downside.

    What? That people are going to call you a Nazi? I think that card has been played.

  18. 18
    Derelict says:

    What they now call “flash trading” to give it a legal veneer used to be known as “front running” and has always been 100% illegal.

    Front running is the practice of putting the firm’s trades through ahead of a client’s trade in order to profit from whatever it is the client is trying to do. Flash trading does exactly the same thing, but uses computers and has a different name. So I guess that makes it better somehow.

  19. 19
    MattF says:

    It’s interesting that the question “Is that legal?” seems to have a time-resolution component… If someone proposed to get a profitable advantage through information on trades a week in advance– well, that’s obviously illegal. A millisecond in advance, though, is a whole different question, apparently.

  20. 20
    Incertus says:

    @Comrade Dread: They also avail themselves of good lawyers to examine the law, find loopholes, and take advantage of them.

    Or write the loopholes into the law in the first place.

  21. 21
    Incertus says:

    @Napoleon: i.e. the originalist theory of Constitutional law. Sorry–I put a little too much snark in my coffee this morning.

  22. 22
    Roger Moore says:

    @PG:

    Where this argument falls apart is when the CRA no longer has the arms-length relationship to the security-creator whose security it is rating that, say, a newspaper has to a restaurant it is reviewing.

    It also falls apart because the rating given by a CRA has a significant legal effect on buyers of the security. The companies putting together securitized debt weren’t buying good ratings just because they thought it would make it look good. They were doing it because the Basel rules controlling capital requirements say that you need less reserve for high rated securities. IOW, the CRAs are effectively regulators, and taking money for ratings is corruption of the first order.

  23. 23
    Martin says:

    Call this flash trading what it really is: frontrunning. In other words they look at all the trades just prior to them being made and make trades accordingly, then they execute the trades of everyone else.

    My understanding is that it doesn’t quite work like that.

    It sounds more like they have another team of guys with another set of computers that basically spoofs the official trading computers with orders to see what they come back with and then makes decisions based on that before any of those orders get executed.

    Basically by tossing up a sell order up against my buy order, and then canceling that order, they can see what I’m willing to buy at before I can actually buy. They can then try and squeeze a buy order in just below mine. The key is that they found out about my order technically from the outside. It should still be illegal, but I can imagine that it isn’t by a lack of technical imagination by the SEC.

  24. 24
    Xenos says:

    @Derelict: We really, really need to put some people in prison for this. Some sort of stock market strike is in order.

  25. 25
    scav says:

    hey, would this be the place to bring back the Technical Thug meme?

  26. 26
    PTirebiter says:

    @joes527 @Just Some Fuckhead:

    That’s Jerry Brown, BTW. He gets around. And how

    You can take the boy out of the Jesuits, but you can’t the Jesuit out of the boy. His old man was California’s the last good Governor. Good schools, good surf and the break out policy of one bed, one convict.

  27. 27
    Bullsmith says:

    Absolutely agree. Rating investments AAA when they’re not actually backed by assets is fraud, plain and simple. Without those BS ratings, big shitpile never comes into being.

  28. 28
    Maude says:

    @MattF: A murder is premeditated no matter what the time frame.
    Under Bush: it was legal, so shut up.

  29. 29

    @Bootlegger: I agree with your hypothesis. (Well, that and no one really gave a shit before). How in the hell could an underfunded, understaffed, incompetent SEC actually prevent this from happening? Not gonna happen. The Wall Street people are very good at finding all the ways to skirt around the law if not completely trounce it.

    In addition, it’s very hard to defend against something that’s never happened before. That’s why it’s always about playing catch up when it comes to technology.

  30. 30
    Napoleon says:

    @Martin:

    And doing it all off of a link into the stream of trading data that they have access to prior to the general public, which to me is the relevant factor.

  31. 31

    @scav: You made me guffaw. Thank you for that. I think this is the exact right place and time to bring back the Technical Thug meme.

  32. 32
    Joe Max says:

    @ joes527:

    @Just Some Fuckhead:

    That’s Jerry Brown, BTW. He gets around.

    And how

    I do believe that’s a picture of Jerry with his former girlfriend Linda Ronstadt and her band.

    I’ve met Mr. Brown several times, nice guy. My daughter’s school, Oakland School for the Arts (think “Fame” on the west coast), was one of his pet charter school projects while he was the mayor. He still keeps an office across the street and shows up at almost all the student performances.

  33. 33
    Joe Max says:

    (Sorry, everything before “and how” was a quote. WP sucks…)

  34. 34
    burnspbesq says:

    The situation with the rating agencies actually used to be worse. The biggest valuation consulting firm in the world, Duff & Phelps, was created as a result of an acquisition of the Corporate Value Consulting practice of … wait for it … S&P.

  35. 35
    gnomedad says:

    @Maude:

    Under Bush: it was legal, so shut up.

    Darth Shrub: “I will make it legal!”

  36. 36
    liberal says:

    @Zifnab:

    I was going to say, it seems to practically be the definition of insider trading.

    I could be wrong—godda get back to work, etc etc—but I thought it was something called “front running.”

  37. 37
    burnspbesq says:

    @Bullsmith:

    The CMOs and similar financial products are backed by assets. The problem is that either (1) nobody know that the assets were shit (the more charitable view) or (2) the assets were systematically overvalued, with malice aforethought. If you can prove (2), you can add a lot of defendants to your lawsuit.

  38. 38
    liberal says:

    @Napoleon:

    And doing it all off of a link into the stream of trading data that they have access to prior to the general public, which to me is the relevant factor.

    Agreed. But IIRC what makes it even worse is that the exchange gets a kickback. Might be wrong about that.

  39. 39
    burnspbesq says:

    One of the biggest regulatory failures that led to the meltdown was the failure to treat credit default swaps as what they are functionally identical to – insurance. Slap a reserve requirement on those puppies, and the notional value of the entire market would have been tens of billions instead of trillions, nobody would have been sweating counterparty risk, and AIG wouldn’t have needed to be rescued.

  40. 40
    liberal says:

    @asiangrrlMN:

    In addition, it’s very hard to defend against something that’s never happened before. That’s why it’s always about playing catch up when it comes to technology.

    Not really true in this case. The folks doing the front-running have to have actual hardware in place at/near the exchange in order to do this. I assume they had some BS story about only doing it to provide liquity or market-making or whatever, but it shouldn’t have smelled right, right from the start.

    I think the main problem with the SEC and other reg agencies is a lack of will. Sure, resources aren’t great. But IMHO it wasn’t lack of resources that let Madoff elude them, for example.

  41. 41
    liberal says:

    @burnspbesq:

    Slap a reserve requirement on those puppies, and the notional value of the entire market would have been tens of billions instead of trillions, nobody would have been sweating counterparty risk, and AIG wouldn’t have needed to be rescued.

    Agreed.

    On a comment thread over at lolfed.com, one of the bloggers made some noises that we wouldn’t want to entirely get rid of CDSs. I said, sure we do. He said, what’s wrong with one party providing another with insurance (for a fee)? I said to avoid the problems we’ve had, you’d need regs (particularly like reserve requirements), and after adding all that stuff, you’re back to conventional insurance anyway.

    I mean, “insurance” as commonly thought of has been around for centuries, and things like reserve requirements aren’t part of the landscape for arbitrary reasons.

    (My impression is that there definitely is conventional insurance. E.g. Vanguard sells an insured muni bond fund, meaning the underlying munis are insured. And I’m sure that’s good old fashion insurance, not this CDS crap.)

  42. 42
    DZ says:

    These rating agencies were key contributors to the real estate nightmare. They would rate CDOs as AAA when they knew that the CDO pool contained more than 30% tranches of sub-prime garbage. So, the CDOs sold well. When real estate prices began to crash, the sub-prime tranches overwhelmed the good mortgages and toxic assets resulted.

  43. 43
    MK says:

    @burnspbesq: This.

    Who’d have thunk that reserve requirements actually serve a purpose?

  44. 44
    MK says:

    @liberal:

    If I’m not mistaken, a couple of things happened (well, much more than a couple but I’m condensing this). First, the term credit default swaps was created and used in order to get away from the traditional reserve requirements that apply for insurance. Because if it’s not called insurance, then the insurance regulations shouldn’t apply. Secondly, active lobbying efforts happened to continue keeping CDS and other financial instruments from being regulated such that things like reserve requirements were never instituted for CDS.

  45. 45
    burnspbesq says:

    @liberal:

    CDSs, like most derivatives, have perfectly legitimate uses as a risk-management tool. When you turn any derivative into a form of gambling, that’s when Sauron gets loose in the markets.

    My regulatory fix for CDSs would have two components. First, a reserve requirement for writers of CDSs. Second, you can’t buy one unless you own the underlying credit instrument, and if you sell the underlying you have to staple the CDS to it or close the CDS.

  46. 46
    Steeplejack says:

    @Incertus:

    I like the hazelnut snark in my coffee.

  47. 47
    Montysano (All Hail Marx & Lennon) says:

    Long time readers know that this has been an issue of interest to me, because I am simply flabbergasted that no one has gone after the Credit Ratings agencies after the Wall Street meltdown the way they went after Arthur Anderesen following Enron.

    Or amazed that Halliburton, KBR, et al can provably rip off the American taxpayers for billions, with the response being *** crickets ***

    Yet ACORN can hire two dumbasses in one of their offices and get the full attention of Congress and the rage of the teabaggers.

  48. 48
    kvenlander says:

    Nobody’s mentioned that Jerry Brown is running for Governor (again). Putting the screws on some banksters is good politics – and good policy of course.

  49. 49
    Left Coast Tom says:

    @MK:

    Who’d have thunk that reserve requirements actually serve a purpose?

    Why do you need reserves if you don’t intend to pay any claims?

  50. 50
    Ecks says:

    @Napoleon:

    And doing it all off of a link into the stream of trading data that they have access to prior to the general public, which to me is the relevant factor.

    I am not in the least an expert here, but my understanding is that they weren’t doing this with the same computers through which they place orders for people (which would be frontrunning), or using computers that had faster access because they were part of the system everyone else used to place orders (which would be using the unfair advantage of their trading equipment to do things other people can’t).

    I think Martin has it right. They just bought a brand new ultra fast computer, and set it up right next to the exchanges computer (which anyone could do, in theory, if they had enough $$$), and took advantage of the slower lag times to place and cancel orders to sniff out what other people’s programmed buy and sell prices were, or what orders they were putting in, or something. In theory it would be the equivalent of just standing next to the trader who’s shouting orders so you can query her faster than others could, which would be perfectly legal because there is no law against it (there was never a need, nobody before was able to act in the time it took sound to get the rest of the way across a room).

    The fact that they’ve taken this legal behavior, and used it to subvert, very clearly, the intent of fair trading laws means that it needs to be rendered illegal stat. It’s cheating on the order of getting around a designated fuel tank size in your Nascar by putting extra long fuel tubes in, so they would hold extra gas there… A creative technicality that is clearly contrary to the spirit but not the letter of the law, and needs stamping out in a hurry.

  51. 51
    IfItsBrownFlushItDown says:

    Jerry Brown Turned himself into a political mercenary when he ran for president 30 years ago. Maybe even earlier.

    He will kiss any ring for a political contribution and exploit any cause for the suckers votes.

    He will stab anyone in the back to become th’gov again.

  52. 52
    JohnR says:

    “..its failure to spot the Ponzi scheme orchestrated by Bernard L. Madoff”

    Since even the most cursory look at Mr. Madoff’s situation would apprently have shown that this was crooked to the core, and since there were explicit warnings about Madoff’s game dating back, what – 15 years? 20 years? – and since not just the SEC but also the IRS gave Madoff a clean bill of health, I think “failure to spot” is simply way too generous. “Criminal complicity” is the phrase that jumps to mind for me. For a really thorough workover, see Velvel’s blog; he’s devoted much of his writings for a while to this topic and I have yet to see any indication that he’s been wrong about much, if anything.

  53. 53
    Allan says:

    Glibertarians, LaRouchebags, Paultards and their ilk have had a free ride for years. Even though they represent ideologies that have rarely been able to persuade a plurality of voters to elect their frontpersons to office, and in fact fail to even offer any concrete path to acheiving such electoral success beyond the basic formulation of:

    1. Our ideas are ever so much smarter for how things should be done
    2. (Through some opaque process, we actually convince a significant number of people to organize themselves into parties and break the hegemony of the two-party system.)
    3. The United States becomes a Glibertarian, LaRouchebag, and/or Paultard nation.

    they continue to take up oxygen and column inches in the media and blogosphere out of all proportion to their actual numbers.

    My advice: use their comments sections, if they offer them, to challenge them to explain exactly how they are going to translate their supposedly superior ideas into electoral success.

  54. 54
    Allan says:

    Oh, and forgot my final point that makes the above tirade relevant to the current topic:

    The Republican Party is on the verge, if not already over the edge, of joining the Glibertarians, LaRouchebags, and Paultards in the sport of impotently complaining from the distant back seat of the bus about the direction the driver is heading. All sound and fury, representing a dwindling and increasingly obsolete constituency, and to no actual impact.

  55. 55
    Allan says:

    Oh crapety crap crap crap. Both the above tirades were intended for the Spitballs R Us thread and I have no idea how I ended up here instead.

    Slinking away from the computer now.

  56. 56
    Sentient Puddle says:

    From the font of totally untrustworthy information known as Wikipedia:

    Front running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers.

    From the article up top:

    Using lightning-quick computers, high-frequency traders often issue and then cancel orders almost simultaneously and get an early peek at how others are trading.

    Minus the “advance knowledge from its customers” part, this seems to me to be pretty clearly calling it a “genital contractor” or “used vagina salesman.”

  57. 57

    […] is investigating the credit ratings agencies that told everyone that risky banking practices were fine, dandy, and safe. Good thing, and about time someone did […]

  58. 58
    trollhattan says:

    Right on Jerry, go get ’em. The credit agencies have long set themselves up as a quasi-governmental agency, without all that pesky oversight. About time.

    I’ll be interesting if we have Jerry vs. the reptilian Meg Whitman for the governor’s race in ’10. I’m well past trying to handicap statewide poly-tiks here. ANYTHING might happen.

    Wolverines! Also.

    I just heard of computerized flash trading a couple of weekends ago and just about drove off the road, so flabbergasting is the concept and technology. How it’s any more ethical than cheating on the SATs by looking at others’ tests is a mystery. Oh, and you already know who the smart kids are.

  59. 59
    DougL (frmrly: Conservatively Liberal) says:

    @Ecks:

    It wouldn’t surprise me if the regular trades were being sent through and processed via 486SX/25 systems on a Token Ring network and the high speed flash trades were being run on the latest computer and network hardware.

  60. 60
    Ecks says:

    @ Sentient. Let’s pretend that you are a trader. The difference is that in the one case I tell you “I would like to buy a million microsoft stocks”, and you say “oh yeah, getting right on that [quietly buy some MS stocks themselves] ah, there we go, here I’m buying them for you right now. Here they are. [quietly sell those MS stocks, now that your order has knocked the price up, thus leaving you buying them for more, and having them worth less now].”

    That’s frontrunning, and it’s illegal. You’re telling them privileged information so they can trade for you, and they’re abusing that trust.

    This is different. It’s more akin to them finding a bug in the stock exchange software, by which you can press up up left down up, and it tells you what’s about to happen. It’s still cheating, but you’re not directly abusing your client’s trust, you’re just screwing the system for money, at everyone else’s expense.

    @DougL – possibly, but I suspect the actually expensive part is renting the real estate right next to the stock exchange so you can be in and out faster. Downtown Manhattan ain’t cheap.

  61. 61
    Epicurus says:

    It was allowed because no one said that it wasn’t legal or proper. The regulators were all issued blindfolds during the Cheney Administration, and wore them well. And since everyone was making a lot of money, everyone was happy. Plus, Goldman Sachs is a soulless pit of avarice.

  62. 62

    What they now call “flash trading” to give it a legal veneer used to be known as “front running” and has always been 100% illegal.

    No. This has nothing at all to do with front running, because these trades have nothing to do with trades made for their own clients. Ecks has it right.

    Beyond this, I will once again point out that there’s nothing new here, except the speed. The way that the NYSE works depends upon someone having all of the information ahead of time. They’re called specialists, and you can’t run a pit without one. (Purely electronic exchanges, such as the ISE have managed to do away with them except when you need to do an opening rotation.) If you think specialists haven’t been abusing their position running the book for a century, you really don’t understand how the exchange works. Specialists fuck you; it’s in their job description.

Trackbacks & Pingbacks

  1. […] is investigating the credit ratings agencies that told everyone that risky banking practices were fine, dandy, and safe. Good thing, and about time someone did […]

Comments are closed.