Who Rates the Raters?

It turns out no one, really:

Earlier this month, the Justice Department and 16 state attorneys general sued the Standard and Poor’s (S&P) credit-rating agency, accusing the company of improperly inflating the ratings of 40 collateralized debt obligations (CDOs)—essentially, securities made up of other mortgage-backed securities—at the height of the housing bubble. According to the suit, S&P misled investors by rating the risky securities as “triple-A,” super-safe investments. But the purchases turned into massive investor losses when the bonds failed after the bubble collapsed. Using emails and other communications, state, and federal prosecutors will seek to prove that S&P knew the securities were junk but rated them highly for the most obvious of reasons: to make more money.

The lawsuit gets at a major problem at the heart of the credit-rating business: Rather than investors paying rating agencies to assess the value of securities it is the issuers of the securities themselves who pick up the tab. It is naturally in the interest of issuers—typically big banks—for rating agencies to rate their products highly, which increases the chances investors will buy them. Under this “issuer-pays” model, the largest credit-rating agencies then have a strong incentive to highly rate securities for issuers who can give them more business in the future. This is said to be part of the reason rating agencies ignored the risks from the highly complex securities and simply let everything pass; in one communication revealed in the filing, an S&P employee boasted, “It could be structured by cows and we would rate it.”

Great piece from D-Day.

54 replies
  1. 1
    minutemaid says:

    Phew…here I thought that link was going to another Greenwald hit piece of garbage. We all know Cole still reads his crap because people with shit for brains tend to congregate.

  2. 2

    Wait, wait, wait… so paying someone to give my product a rating means that they’re more likely to rate it high just to make me happy so I’ll give them more money to rate future products?

    The hell you say.

    I just wonder why the hell anyone bothers listening to anything these ratings whores have to say anymore.

  3. 3
    maya says:

    That explains everything: Wall Street was in a Cow market.

  4. 4
    Jay in Oregon says:

    @Comrade Dread:
    The biggest reason is because there are a lot of places where, by law, investment funds such as pension funds can only buy into securities that are rated triple-A.

  5. 5
    Forum Transmitted Disease says:

    Not overseeing the people who determine the worth of, well…everything.

    What could go wrong?

  6. 6
    dr. bloor says:

    “It could be structured by cows and we would rate it.”

    Coming soon: Too Big to Broil.

  7. 7

    @Jay in Oregon: Yeah, but if you’re running a pension account, and you know the ratings agencies are being paid by the people who are trying to sell you shit sandwiches, why would you trust anything they had to say?

    I mean, if I knew for a fact that all Yelp reviews were done by people hired by the restaurant, I’d just assume they were all lies and go to a place I already knew was good from experience.

  8. 8
    gene108 says:

    Sometime during the Carter administration a rule was passed that required financial instruments, such as bonds, to be rated before they could be sold commercially.

    I forget the reason, why this happened, but this changed the nature of the rating agencies from paying for people, who wanted to purchase a security to the people paying being the folks issuing the security.

    For whatever reason – like the Community Reinvestment Act from the Carter era – there enough checks and balances in place to keep things from totally getting screwed up for about 20 years.

    In all honesty, the rating agencies are just one cog in this mess. The whole financial services industry got too greedy and too “sophisticated” for anyone’s good.

  9. 9
    Fake Irishman says:

    Dodd-Frank actually has some things that will alleviate this. The idea was to stay with the issuer-pays system, but to put all the raters into a pool. If you’re a bank who needs a rating, you put in a request to the pool, and get blindly and randomly assigned a rater. Raters get vetted by the SEC. (I think this stayed in the final bill, and the devil is in the rule-making, but this usefully realigns the incentives.)

    I believe Al Franken was the guy who came up with the suggestion.

  10. 10
    dday says:

    @Comrade Dread: What if there are only three Yelp reviewers that do 92% of the reviews? That’s the nature of the oligopoly right now with S&P, Fitch and Moody’s. Institutional investors have the capacity to do some of their own analysis, but that only goes so far.

  11. 11
    General Stuck says:

    This leads to an obvious question: If the rating agencies have an inherent conflict of interest—something even the Justice Department, which is notoriously averse to prosecuting financial crisis-era cases, sees as illegal activity—why has the government not yet overhauled the way rating agencies get paid?

    Maybe after Dday has decompressed and is deprogrammed from the argle bargle firebagger mother ship, he will leave out such red meat tossings for the Obama haters on the left. To get his mind right, and some sense of fucking perspective.

  12. 12

    We need an FDA like body that does robust testing of all these financial instruments. Will not happen with GOP controlling the Congress.

  13. 13
    TenguPhule says:

    “It could be structured by cows and we would rate it.”

    So that’s why those CDOs were so full of the shit of the bull.

  14. 14
    Xenos says:

    @schrodinger’s cat: Other people in other places seem to be able to come up with a regulatory system that can at least try to stop the abuses by the rating agencies. It is quite a shame that the US can’t even collect the political wherewhithal to at least try to do this.

  15. 15
    David Hunt says:

    @Comrade Dread:

    I just wonder why the hell anyone bothers listening to anything these ratings whores have to say anymore.

    The way I figure it, if they don’t use the ratings from these guys then they don’t have anything that rates the risk level of securities. Doing that kind of diligence on a security is time-intensive, expensive, and the accuracy depends on what information you can get access to. Most of Wall Street probably figures that they’re better off on average just using them.

    Also, it didn’t use to the be issuer that paid the rating agency. People interested in a security would pay the rating agency a fee and the rater would print them up a copy of their report (they did reports on all the major securities). Unfortunately, the photocopier did that model in. Once a report was given to someone, everyone had it quicker than that a New York minute and the raters had to find another way to make money from rating securities. This is where the current model of having the issuer pay for a report came from…

  16. 16
    ThatLeftTurnInABQ says:

    @Forum Transmitted Disease:

    Not overseeing the people who determine the worth of, well…everything.

    What could go wrong?

    “There must be some way out of here” said the joker to the thief
    “There’s too much confusion”, I can’t get no relief
    Businessmen, they drink my wine, plowmen dig my earth.
    None of them along the line know what any of it is worth.

  17. 17
    Ted & Hellen says:

    @General Stuck:

    Maybe after Dday has decompressed and is deprogrammed from the argle bargle firebagger mother ship, he will leave out such red meat tossings for the Obama haters on the left. To get his mind right, and some sense of fucking perspective.

    IOW, you have no non-Bot cover story answer to his question, oh pompous one.

  18. 18
    White Trash Liberal says:

    @General Stuck:

    Perhaps because those very rating agencies keep threatening the US economy with downgrades?

    I have been pointing out the rating agency malfeasance as central to the financial crisis.

    CRAs are an oligopoly. They need to be broken… But first their relative value has to be questioned because they have wielded undue influence on the US and European crises.

  19. 19
    Fwiffo says:

    There’s a simple, market-based solution to this problem. Allow for the creation of Credit Rating Agency Rating Agencies (CRARAs) to rate the ratings of the CRAs. The create tradeable derivatives of the rating-ratings, create some rating-rating-default-swaps as a hedge, repackage them as securities, and sell them to Iceland and other municipalities.

    You’re welcome.

  20. 20
    White Trash Liberal says:

    @Ted & Hellen:

    The short answer is: no one wants to do anything. If you read between the lines, not only is the SEC stalling, but so is Franken and others for putting the onus of reform on an understaffed agency.

    We should be celebrating the DOJ wading into this mess. The global speculation market and the guardians of its myriad transactions are insane. Trying to devise cybernetic models to calculate risk while at the same time pushing the contradiction of “safe risk” as the only safe allocation of investment. It’s a model that is designed to be undermined.

  21. 21
    General Stuck says:

    @White Trash Liberal:

    CRAs are an oligopoly.

    Our entire economic system is shot through with “opolies”, into an ever tightening mass of collusion that will own every man woman and child from cradle to grave, if they don’t already. Rating agencies are the disc jockies of excessive greed. They spin the records, much like the speculators and the gaggle of educated fools dreaming up ways to rob you blind. We are all marks employees at Mordacai Jones Inc.

  22. 22
    General Stuck says:

    @Ted & Hellen:

    What question was that? I didn’t see any question in my quote of Dday in that comment. It was more a statement of fact he made, without saying why.

  23. 23
    Xenos says:

    @Xenos: Let me correct that. The EU actually considers US rating agencies to be regulated to a comparable degree as european agencies, and to accept their judgments along with Canadian and Australian ratings.

    The stuff those guys in Brussels will accept is pretty stunning. They actualy believe that American regulations are consistently and assiduously enforced. They have no fucking idea about how bad American governance can get.

    Reminds me of one of the securitization classes I took at the local law school. The prof explained how, in the subprime crisis, American banks lent money to people based on security interests in houses MADE OF WOOD. Not stone, not brick, WOOD. The students were shocked, like if I told you a bank issued a mortgage loan on some kid’s tree house. “WOOD? You must be kidding me…”

  24. 24
    General Stuck says:

    @General Stuck:

    something even the Justice Department, which is notoriously averse to prosecuting financial crisis-era cases

    This was what I was talking about. Not the fact that the US government is going after them, and that they are a problem.

  25. 25
    White Trash Liberal says:

    @Xenos:

    What is frightening is the notion of “comparable degree”… I believe the EU is saying that all the ratings agencies are no better, no worse, comparatively. Not that American craziness is overlooked, but that the whole global system is equally hinky.

  26. 26
    FlipYrWhig says:

    @General Stuck:

    why has the government not yet overhauled the way rating agencies get paid?

    If stuff sucks, why has the government not yet made stuff un-sucky?

    “Why has a fix not happened yet?” seems like the most jagged way to ask such a question, because, as Stuck points out, it basically cries out for the answer “because they don’t want it, corruption and corporatists, that’s why!”

    “How could a fix happen at all?” seems appropriate. Of course, that inevitably leads to reasonable but un-fun answers about how good ideas even in the hands of smart and sympathetic politicians and regulators have to run a gauntlet of badly informed politicians, wicked lobbyists, and just plain doucheweasels.

  27. 27
    General Stuck says:

    IOW’s there is an assumption by our progressive betters, that if things are not happening as they wish, it must be a lack of will “averse” on the Obama admins part, for whatever reason that comes to mind. Though never that it could be a function of lacking resources, and picking priorities to go after in a white collar crime wave. Or the enormous task of untangling the seeming endless entanglements that make for our modern finance system.

  28. 28
    General Stuck says:

    @FlipYrWhig:

    Yes, very much so. thank you.

  29. 29
    Villago Delenda Est says:

    @Xenos:

    And what, apart from wood, floats?

  30. 30
    Villago Delenda Est says:

    The people who run the ratings agencies are drawn from the same backgrounds as the people they’re supposed to be rating.

    So, the problem becomes one of are you honestly going to evaluate a friend’s security offering? Even after you have done all the very time consuming, labor intensive research to support your rating?

    This is the problem with what we’ve got now, a virtually unregulated crony-capitalist financial sector.

    Someone, who has security in their position, and puts their integrity over the long term first in their priorities, is needed to perform this function.

    We don’t have that right now. It was demonstrated five or six years ago when analysts told their bosses “the market is tapped, there’s nothing else to go after” in mortgages, and the bosses, who wanted their growth numbers not to be sustained, but increased, told them to go back and make it so. So standards were abandoned and soon anything goes was the watchword.

    The result was the meltdown of 2008.

  31. 31
    FlipYrWhig says:

    @General Stuck: Right — I think there are at least two possibilities: things haven’t been fixed because their fucked-up state is deeply entrenched and un-fucking them is a tall order; or things haven’t been fixed because the Obama administration doesn’t care enough to fix them, or actively doesn’t want to fix them. The FDL way is to lean VERY hard on the latter possibility, and to scoff at people who raise the former possibility as making excuses or being naive. But, you know, that’s fine, that’s a style.

    OTOH, it seems to me that if you want to be an activist and not just a gadfly you ought to offer an idea about what might be done to shepherd that badly-needed unfucking through an unfair and inertia-addled political system. Because, irrespective of whose fault it is that things are fucked, their fuckedness isn’t going away by the sheer force of harrumphing.

  32. 32
    ThatLeftTurnInABQ says:

    @Villago Delenda Est:

    We don’t have that right now. It was demonstrated five or six years ago when analysts told their bosses “the market is tapped, there’s nothing else to go after” in mortgages, and the bosses, who wanted their growth numbers not to be sustained, but increased, told them to go back and make it so. So standards were abandoned and soon anything goes was the watchword.

    With benefit of hindsight it looks to me as if there were so many positive-feedback loops built into our financial markets circa mid-90s thru mid-00s, and so few structural elements remaining in place to act as dampers or firewalls, that the wonder isn’t that they blew up in spectacular fashion, but rather that it took them so long to do so. Any system structured that way was a bomb primed and waiting to go off.

  33. 33
    Lurking Canadian says:

    In Ontario, we have a law that industrial workcells must be reviewed by an engineer. The review is paid for by the owner. As a result, the same moral hazard exists.

    However, we avoid it because the wrath of God descends upon any engineer who signs off on an installation that later injures a worker.

    It seems that this could be fixed if there were similar dire consequences for ratings agencies who highly rated securities that failed, and were later determined to have been obvious trash all along.

    But that would require a regulatory agency with teeth, and that would require unbribed senators, so it is not likely.

  34. 34
    rda909 says:

    @General Stuck: Dude, Che GueNader would’ve bully-pulpitted that shit right quick, brutha! The Online (99% white) People’s Progressive Party is gonna storm the online petitions! Charge, brothers and sisters, and WE will stop this evil Obummer from selling US out to Wall Street any more! And we better do it fast before Hopey-Changey dronezzz us dirty hippies into catfood, which he’ll then feed to our grandmothers!

    I’ll be back in a bit to give you all some links to get “active,” but first I gotta take my new MacBookPro down to the Apple Store to get a better graphics card put in so I can play better games (hey, keeps my skillz sharp for all my online “activism”) SOLIDARITY! MIC CHECK!

  35. 35
    Baud says:

    I find it interesting that, in the discussion about fighting the big banks over the last few years, I haven’t seen more references to Andrew Jackson. Maybe Old Hickory was too much of a bastard to the non-whites to be mentionable. But he hated big banks.

  36. 36
    General Stuck says:

    @rda909:

    Teehee

  37. 37
    rda909 says:

    @FlipYrWhig: ” …or things haven’t been fixed because the Obama administration doesn’t care enough to fix them, or actively doesn’t want to fix them.”

    So that’s reasonable option, huh? Damn, that Obummer is so tricky! He started writing about these topics in depth as a teenager and throughout his life, and that whole community organizing thing decades ago was just a ruse to fool “us,” his base, into voting for him so he could do Wall Street’s bidding and destroy Social Security, but as a Democrat! And to think he didn’t really mean it, or understand it when he said all this….disgusting!
    http://www.youtube.com/watch?v=U9G8XREyG0Q

  38. 38
    Ronzoni Rigatoni says:

    Jeebus. Lookit Enron who subverted every accounting firm and anybody in line to handle new stock sales unless they provided good things about the company. Accountants were fired for expressing doubts. Rating firms were throttled. Thissiz newz?

    Here we go agin.

  39. 39
    FlipYrWhig says:

    @rda909: I don’t find it to be a reasonable option myself, but it’s certainly treated as a reasonable option in many of the tonier precincts of the blogosphere.

  40. 40
    Roger Moore says:

    @Comrade Dread:

    I just wonder why the hell anyone bothers listening to anything these ratings whores have to say anymore.

    Because those ratings have legal ramifications. Banks are required to have a certain level of reserves to cover their depositors’ money, and those reserves can include securities other than cash. The exact amount of the reserves depends on the quality of the securities, with higher rated securities worth a larger fraction of their face value. So the ratings have a practical effect on how banks deal with bonds.

    Also, too, many other kinds of business deals that involve companies having to keep specific levels of reserves may include terms that specify the quality of securities that can be used. For example, credit default swaps may require the seller to back the CDS with an amount of cash that depends on the rating of the security. As bond ratings fall, the seller needs more and more money to back the CDS. That caused huge problems during the financial crisis, because AIG was contractually required to have huge amounts of cash just at the point that nobody was willing to loan any money.

  41. 41
    Ronzoni Rigatoni says:

    @Comrade Dread: I already mentioned the Enron experience. Bow your heads for the demise of Arthur Andrerson. The conflict of interest was appalling. Go, Sr Sen fm Mass.! The DOJ has a lot
    of work to do, if they ever get around to it.

  42. 42
    Roger Moore says:

    @Xenos:

    The stuff those guys in Brussels will accept is pretty stunning. They actualy believe that American regulations are consistently and assiduously enforced. They have no fucking idea about how bad American governance can get.

    What makes you think the folks in Brussels are any more assiduous about enforcement of financial regulations than we are? Their bureaucrats are even less accountable than ours are. The LIBOR scandal ought to be a sign that all is not well on the other side of the Atlantic.

  43. 43
    dmbeaster says:

    I do not buy into the idea that the ratings agencies somehow were critical in setting up the bubble.

    There may well be liability for the 40 offerings that are the subject of the suit, and sticking them with liability may be helpful in reforming their practices somewhat. But their role in creating the crash is over-hyped. For example, I don’t think Lehman, Bear Stearns, or Merrill Lynch lost their shirts because they were duped by the ratings agencies into taking a big position with these securities.

    Realize that a lot of these offerings got AAA ratings because they were backstopped by AIG, which lent to the offerings its sterling credit rating. The issuers packaged the offerings with AIG in such a way so that the rating agencies could comfortably give them the AAA rating. And since the swaps issued by AIG were completely unregulated, it was able to essentially issue insurance many many times its actual ability to pay. Perhaps they did that because they did not believe a systemic melt-down was possible, but its similar to an insurer issuing all of the earthquake insurance for LA — one event, and you are wiped.

    The institutional investors were well aware of the incestuous relationship between issuers and rating agencies. They took that into account when deciding what to do.

    The real driving force was the willingness of the the mortgage creators to throw all underwriting standards out the window in order to create more product for the CDOs. Which in turn made money very cheap and easy for purchasing homes, which drove up values, which lent a false security to the bubble created by this feedback loop. The position of the ratings agencies represented the dominant thinking by many fully knowledgeable concerning the market. The rating agencies reflected and reinforced this conventional wisdom as opposed to creating it.

    There was talk in 2007 and 2008 that there was a bubble that would burst, and some got very rich betting on that outcome. The meltdown was unregulated capitalism at its finest – in the true boom/bust cycle that was the norm pre-1930s. And remember those prophetic words of Greenspan concerning this – that he had discovered a flaw in his system. Another root cause of the melt-down was that so many believed that unregulated capitalism would not engage in such self-destroying speculative frenzies, despite financial history indicating otherwise.

  44. 44
    Maude says:

    @Roger Moore:
    The problem was that CDSs weren’t considered insurance and didn’t have to have the capital to back them in case CDOs went belly up.
    Bill Clinton has a lot to answer for with the Commodity Modernization Act of 2000. It was the biggest gift he could have signed into law for Wall Street. They had been trying hard since Reagan to get it.
    Clinton has skated on this.

  45. 45
    FlipYrWhig says:

    @Maude: And that law is a good example of harm actively being done to the idea of regulation. Even the most vociferous Obama critics and skeptics don’t have a smoking gun like that. At most they have examples of blind spots and slow movement where attentiveness and quick response would be better. I’d kind of like for them to admit that there’s a difference between “Why haven’t they fixed it yet?” and “Why did they break it?”

  46. 46
    Roger Moore says:

    @FlipYrWhig:

    Right — I think there are at least two possibilities: things haven’t been fixed because their fucked-up state is deeply entrenched and un-fucking them is a tall order; or things haven’t been fixed because the Obama administration doesn’t care enough to fix them, or actively doesn’t want to fix them.

    With the first possibility, I think you need to include the idea that there are people who are trying as hard as possible to keep things in their current fucked-up state. The Republicans are still trying to cripple the CFPA, undo Dodd-Frank, and generally prevent anything that remotely resembles regulation of the financial industry. Given that there’s some reason to think that the worst abuses leading to the financial crisis were things that were legal but shouldn’t have been, that makes it very hard to fix the underlying problem.

  47. 47
    El Cid says:

    This is all a distraction from how Jimmy Carter put ACORN in charge of the ratings agencies so that Barney Frank could force up the value of undeserving lazy black banks.

  48. 48
    Ronzoni Rigatoni says:

    I am so fukkin’ pissed when “my” broker, Chas Schwab, asked me if I’d accept an 8 /12 % monthly return if I shifted my CountryWide holdings to CititBank. Whee. No explanation other than “they just like your stock.” Paid my mortgage. I was too pre-occupied to realize that Citibank was shorting the stock (based on an SEC filing by the CFO in Dec., 2027, which I missed). Whee! In Feb., 2008, I lost $240,000, and, because of after-hours trading, I couldn’t unload until the following Monday at $10.00 a share

    I think Vegas’ odds are far better. These days I rely on the Racing Form.

  49. 49
    White Trash Liberal says:

    @dmbeaster:

    The banks weren’t duped. Investors were. The ratings agencies were vital to conning investors.

  50. 50
    liberal says:

    @Fake Irishman:

    Dodd-Frank actually has some things that will alleviate this. The idea was to stay with the issuer-pays system, but to put all the raters into a pool. If you’re a bank who needs a rating, you put in a request to the pool, and get blindly and randomly assigned a rater.

    Would obviously be better than the current system, but some people in the know claim this won’t really fix the problem.

  51. 51
    burnspbesq says:

    @Ted & Hellen:

    IOW, you have no non-Bot cover story answer to his question, oh pompous one.

    Stuck may not, but I do.

    D-Day completely misstated what is going on. If you had read the complaint, you would know that the so-called “inherent conflict of interest” has nothing at all to do with the conduct that is alleged. The misstatements of which S&P is accused would be fraudulent whether there were a conflict of interest or not.

    In addition, the changes needed to eliminate issuer-pays probably can’t be done by way of SEC rule-making. It will take Congressional action, which I suspect even an ignorant sack of shit like yourself would readily concede isn’t going to happen until at least 2015.

  52. 52
    burnspbesq says:

    @Ronzoni Rigatoni:

    Lookit Enron who subverted every accounting firm

    False. Only Andersen had any involvement in the Enron shenanigans.

    You remember Andersen, dontcha?

  53. 53
    dmbeaster says:

    @White Trash Liberal:

    The banks weren’t duped. Investors were. The ratings agencies were vital to conning investors.

    This is not true. Most of the investors were smarter and more skilled at analyzing the product than the rating agencies. The truth in the industry is that the more marginal analysts end up at the rating agencies. The better talent gets to be in charge of the large funds that are the big investors. The banks were hiring the best talent out of the rating agencies and paying them far more.

    Ratings agencies basically perform due diligence pursuant to generally understood and accepted standards for analyzing credit risks for debt instruments. They reflect the conventional wisdom, and save someone time by not having to reinvent the wheel in researching a company. They are not good at analyzing novel situations.

    The mortgage backed securities were not that complicated – even with all of the weirdo traunches and the slicing and dicing of the pool of mortgages for different rates of return based on risk. The key to analyzing them was believed to be the historical rate of return and default rate of home mortgages. To the extent there was uncertainty, AIG’s role in insuring the risk served to cure uncertainty. The analysis assumed that the mortgages being created for the pools were underwritten pursuant to the same historical criteria, which over time became startlingly untrue.

    It is worth noting that the same pattern of bubble has occurred before, although not anywhere approaching this scale. In the 1980s, there were a series of scandals involving insurance companies issuing loan guarantees for commercial construction, which then skewed the risk in making such loans resulting in a rash of bad loans, which then ruined the insurance company that was covering the risk on these loans, resulting in massive loan losses because the insurance could not cover the defaults. “Massive” as in $100 million for BofA alone, which is now chickenfeed thanks to the wonders of deregulation.

  54. 54
    jh says:

    Institutional investors weren’t duped. They, like the ratings agencies played ball because what else were they gonna do? NOT invest?

    They had to invest somewhere and the ratings agencies granting crappy securities AAA ratings provided the large institutional investors with enough legitmacy to cover them when shit went bad.

    The ratings agencies are just one link in the chain of fraud that started at the orginiation of bad mortgages and ended with CDOs.

    Nevertheless, they knew exactly what they were doing and they should be completely overhauled. There definitely should be prohibition on issuers paying for ratings, and there should NOT be a 3-firm cartel controlling the entire business.

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