Standard & Poors: The Arthur Anderson of Housing

[_MeDotOrg]

Arthur Anderson was the accounting firm that repeatedly signed off on Enron's shady accounting practices. Why? because if they didn't, Enron would have taken their business somewhere else.

Monday the Justice Department file suit against Standard & Poors (the largest credit rating agency) , charging them with fraudulently inflating the credit rating of C.D.O.s (Collateralized Debt Obligations) the financial instruments used to bundle debt (mortgages, car loans, student loans, etc.) into investments that were sold by financial institutions.

Most CDOs were given a AAA rating, even though it became increasingly obvious that many of the mortgages being bundled were risky Sub-prime loans, Standard and Poors (as well as Moody's and other agencies) continued to give the coveted AAA ratings to CDO's they knew were dreck. Why? because if they didn't, they wouldn't be asked to rate the next CDO.

This is such an obvious conflict of interest: As a ratings agency, if your income is predicated on how many ratings you perform, and the number of ratings you perform is predicated on how well you rate the products, aren't you going to be, ah, optimistic in you ratings?

So how can we expect a ratings agency to be objective when their income is predicated on giving optimistic ratings?

[_cinepro]

I hope there's a good reason it took four years, but good for them for finally doing something.

As someone who works in quality control, I find the following argument silly bordering on absurd:

S&P has acknowledged that its AAA ratings on many mortgage-related securities turned out to be wrong, but it denies committing fraud. The firm insists the bad ratings were honest mistakes made at a time when few bankers, investors, or regulators saw the dangers posed by out-of-control subprime lending. Even Federal Reserve chairman Ben Bernanke famously downplayed subprime risks, saying in 2007 that "we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."

http://www.usnews.com/news/blogs/rick-n ... ard--poors

Quality Control is the business of seeing things that others can't (or don't, or won't). The reason my clients send me stuff to QC is because we see things that they've missed, and that is a valuable service for them.

If something is missed on a product, it is very, very tempting to blame the manufacturer who made the original mistake. After all, we're only Quality Control; we didn't actually make the product, so how could the mistake be our fault?

But such an argument doesn't absolve us of our responsibility, it only absolves us of our usefulness and relevance to the process. It is arguing against whether or not we provide any value to the equation!

In other words, any company that would set themselves up as "Quality Control" and seek to pass judgement on other products or services must accept the responsibility of that endeavor. The quote above is S&P shirking that responsibility,and with that argument they should go out of business because the service they provide is worthless by their own admission.

[_Gadianton]

So how can we expect a ratings agency to be objective when their income is predicated on giving optimistic ratings?

Most businesses have conflicts of interests to navigate. In this case, income was also predicated on subscribers, and one would hope long-run integrity and reputation with the consumers of their information would outweigh the short term prospects of inflating ratings. But here, there's a double incentive for dishonesty because the other half of the problem was the consumers. Normally, a fund manager would want the truth, not the hype. But there can be exceptions. In the case of large funds seeking stability, pension funds etc., when there are government regulations demanding AAA ratings, and AAA rating bear tiny streams of returns when interest rates are so low, then a fund manager who may wish to bear a little risk but isn't allowed may welcome a return that's suspect for its risk class while technically covering himself. There is an analogy here to home appraisers. During the refinance craze that went hand in hand with balloon loans, both the initial lender and the buyer had major incentives to overvalue their appraisal, and the lenders knew who to call to get the right number.

Where the appraiser analogy breaks down is in the charge of rating an AAA package that is "crap"; that is more severe than fudging an appraisal by 20k. To the extent that there was "looking the other way" my hunch is that parties on all sides of the deal believed the overrating was moderate, not outright fraudulent. It is true that the "good" CDOs consisted of subprime loans. But I don't think that was a secret, because the whole "genius" of a CDO is the pricing model behind them, one that had proven useful elsewhere. The intuition is that the risk of default in New York shouldn't be correlated with the risk of default in Montana, so that by diversifying over the whole country; if a home in New York defaults, that might indicate increased risk of others in New York defaulting, but not Montana. The exposure is mitigated by diversifying. Obviously, the models were incorrect. They were probably designed with foolhardy ambition and greed, but it wasn't the case of outright labeling a piece of crap as a diamond. In retrospect it's easy to say that. It's also been pointed out that he CDOs inventors were among the elite finance wizards, while the analysts at S&P and Moody's were the B students, the "5-figure" earners in the industry. There's a lot of factors here in addition to greed and incentive, including government policy that backfires.