Affordable Housing Institute : US

By: David A. Smith

 

“Just wait ’til your father gets home, young man, and then you’ll really be in trouble!” 

 

Mother, I’m trying to look intimidated by you

 

After hearing that threat, how often were you able to wriggle out of your deserved punishment?

 

That’s the current don’t-you-dare-smirk posture of Congress toward the Big Three rating agencies, who by putting their heads down and making industrious noises appear on their way to a return to pre-crunch business levels and their pre-crunch business model.  At least according to the New York Times:

 

When the financial crisis began, few players on Wall Street looked more ripe for reform than the Big Three credit rating agencies.

 

It wasn’t just that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, played a crucial role in the epochal housing market collapse, affixing their most laudatory grades to billions of dollars worth of bonds that went bad in the subprime crisis.

 

Making this infuriating is that Congress’s paralysis is entirely of its own making, for the solution is at hand if only Congress or the Administration had the political backbone to enact it.

 

And we’re slow, too!

 

Two years ago, at the cusp of the subprime collapse [August, 2007 – Ed.], in a symbiote’s life is not a happy one [Full five-part post here: Part 1, Part 2, Part 3, Part 4, Part 5 – Ed.], I laid out the bones of a solution for rotten rating agencies, analogizing to the challenge facing a sports league whose referees’ integrity is questioned:

 

Whaddaya mean?  Best referee money can buy!

 

The NBA is suffering through a scandal of epic proportions: a referee who’s pled guilty to influencing the course of games – and possibly even the most recent NBA championship – by the way he called fouls to manipulate the over/ under line. 

 

Could one man bring down a league?

 

NBA referees are paid a tiny fraction of the money the athletes make, and an even smaller fraction of the money the NBA owners (their employers) make.  Placing that much responsibility in the same hands as that much temptation is a risky proposition.  Precisely the same scaling/ temptation dynamics apply to the agencies, the investment bankers they referee, and the capital markets who profit from their refereeing.

 

Sports leagues are closed networks of entities that collaborate on network health even as they compete with each other for prizes within the network.  If the network’s brand value drops, all the competitors suffer too.  The capital markets and structured-finance investment banking worlds are a league of professionals who compete on many levels but collaborate on others, including the health of the financial ecosystem and the free flow of ample liquidity. 

 

So it should be no surprise that when a league’s integrity is threatened, the league takes steps to restore its impartiality.  The NBA is now struggling to do that in the wake of Donaghy; 88 years ago, major league baseball did it after the Black Sox Scandal.

 

Players and their lawyers … first in a century-long trend

 

Back in 1919, the owners – a rogue’s club if ever there was one – searched out a person of unquestionable public integrity (Judge Kenesaw Mountain Landis) and appointed him Commissioner of Baseball, with sweeping powers.

 

I’m the commissioner, and I’m nobody’s friend

 

Landis’s reign – and the immense popularity of live-ball and Babe Ruth – gradually brought baseball back from its depths. 

 

Who then is the Commissioner of Rating Agencies?  Surprisingly, there is none.  [Snip]  If not – well, the world can function perfectly well with only two rating agencies instead of three.

 

Even as we flagellate the rating agencies, let’s acknowledge there’s plenty of culpability to go around.  (”All the other kids were doing it, Mom!”)  Yet culpability is absolute, not relative.  That others were culpable does not exculpate you.  (”If all the other boys ran off a cliff together, would you do it?”)

 

I don’t care what the other bloggers are doing!

 

It was the near universal agreement that potential conflicts were embedded in the ratings model.

 

They were.  They are.

 

For years, banks and other issuers have paid rating agencies to appraise securities — a bit like a restaurant paying a critic to review its food, and only if the verdict is highly favorable.

 

More like a restaurant paying a health inspector to certify the little pieces parts were edible, with no liability when the customers died of ptomaine poisoning.

 

Don’t enact anything, and one day you could be like them!

 

Without question, the credit rating system is one of the capitalism’s strangest hybrids: profit-making companies that perform what is essentially a regulatory role.

 

Not any stranger than certified public accountants, who audit financial statements for a fee, paid by the company being audited. 

 

The companies serve the public, which expect them to stamp their imprimatur on safe securities and safe securities alone. But they also serve their shareholders, who profit whenever that imprimatur shows up on a security, safe or not.

 

Again, no different from accountants, except that auditors can be sued and bankrupted – sayonara Arthur Andersen, hasta la vista Laventhol & Horwath.

 

En-what-ron?

 

Making this so exasperating is that the solution lies at hand, if only we had the wit to see it and gumption just to do it.  Capital markets are a large multi-player game with ever-changing participants.  Games have rules, and rules must be interpreted, adjudicated, and enforced by referees.  Referees, in turn, must be capable, disinterested, and accountable. 

 

The rating agencies could be the Referees of Risk Assessment, if their business model were circumscribed to make them capable, disinterested, and accountable.  Like this:

 

 

Simple, isn’t it?

 

It’s easier to remember that way, too

 

We do need rating agencies:

 

The Big Three, by allowing companies and public entities to raise money by issuing debt, are an essential engine in the country’s vast credit factory, and given the still-fragile condition of the equipment, lawmakers are reluctant to try anything but basic repairs, patches and a new alarm system.

 

Isn’t that always the claim? 

 

Mr. Kanjorski said he worried about remedies that undermined the Big Three because they were pretty much the whole system right now.

 

“We want to do as much correction as we can,” he said, “but we don’t want to kill the institutions because we have nothing to replace them with.”

 

If we have three of them, why not shoot one, pour encourager les autres?

 

Yet all is for the best in this,

The best of all regulatory systems

 

There is no talk about creating a fee-financed, independent credit rating agency, one modeled along the lines of the Public Company Accounting Oversight Board, which was established to oversee auditors after the Enron debacle — an idea floated by Christopher J. Dodd, the Senate Banking Committee chairman, as recently as August.

 

That approach would attack the conflict of interest problem head on.

 

Yes, it would.  Why isn’t it being done?

 

Senator Jack Reed of Rhode Island … has listened in recent months to lots of proposals that would have aimed at the issuer-pays system and promoted alternatives. He also looked at the idea of curtailing the importance of ratings by rewriting rules and laws that require mutual fund and money managers to stick to triple-A securities.

 

But he was concerned about the huge numbers of professional investors out there — like those working for small towns — who don’t have the resources to research every bond they buy.

 

Much though I like Senator Reed, he’s forgetting two things: (1) Small investors who don’t research every bond can buy only bonds they research.  (2) If the marketplace for ratings were robust, new entities would enter the field.

“We all understand the outrage, but our priority is to prevent this from happening again … ” — Jack Reed, senator from Rhode Island.

 

In addition, legislators say, there is little consensus about what a top-to-bottom renovation should look like.

 

That’s a copout, what with all the political oxygen being sucked up by siege warfare like the health-care reform debate.

 

Under bills that legislators are currently considering, the rating agencies will have to contend with greater oversight, stiffer rules about disclosure and a provision that would make it easier for plaintiffs to sue the firms.

 

Translation: “When he gets home, your father will know what to do with you.”

 

Wipe that grin off your face, and start looking scared.

 

But nothing in the laws tackles the critic-for-hire problem or threatens the 85% market share that Moody’s, S.& P. and Fitch now enjoy.

 

See Point 1 of our modest proposal – establish licensing standards and open the field to new entrants.  Specialists would emerge for each asset subclass.

 

To make matters more complicated, rating agencies are deeply entrenched in millions of transactions. Statutes and rules require that mutual fund and money managers of almost every stripe buy only those bonds that have been given high grades by a Nationally Recognized Statistical Rating Organization, as the agencies are officially known.

 

Then defrock one of them.  You don’t need three.

 

You’re branded for life

 

Up to now, the rating agencies have enjoyed the upside of their optimistic ratings – enormous fees and record profits – without the downside – litigation judgments.  Though some are trying …

 

When he filed his suit, Ohio’s attorney general, Richard Cordray, said that the “rating agencies’ total disregard for the life’s work of ordinary Ohioans caused the collapse of our housing and credit markets and is at the heart of what’s wrong with Wall Street today.”

 

Ratings agencies’ disregard is “at the heart of what’s wrong with Wall Street today.” — Richard Cordray, attorney general of Ohio.

 

After the suit was filed, Richard Blumenthal, Connecticut’s attorney general, said he planned to join the suit and thought that a “coalition of states” would also jump on the legal bandwagon — a potentially grim development for the rating agencies, which could find themselves contending with a phalanx of state officials like the one that aimed at big tobacco in the 1990s.

 

The Big Three object that the legislation proposed by Congress could make them more vulnerable to legal action.

 

Poor babies.

 

Even if there is no foolproof way to reform the rating agencies, the measures that Congress is now backing are strikingly weak, a number of critics say.

 

Why?  How hard this be?

 

It’s hard, dood

 

[Continued tomorrow in Part 2.]

 

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