It’s been four years since the financial crisis, and no Wall Streeter has gone to jail for it or even paid out a penalty severe enough to cost him his palace in the Hamptons. Still, in this as in most things, one can say better late than never. The Justice Department’s lawsuit against the Standard & Poor’s ratings agency, announced Tuesday, may be overdue, but at least it is happening. And if DOJ sticks to its principles and demands an admission of wrongdoing from S&P in the end—which is likely to be a big sticking point—that will be a real achievement.
But let’s not sidestep the real issue. As Justice's lawsuit indicates, ratings agencies such as S&P and Moody’s were central players in the historic fraud that was the subprime-mortgage securities catastrophe. According to the 2011 report of the Financial Crisis Inquiry Commission—and Tuesday’s lawsuit—S&P’s process for rating securities during the subprime-mortgage bubble was utterly corrupt. The firm knowingly gave inflated AAA ratings to bad securities in order to satisfy its investment banking clients. “Put simply, this alleged conduct is egregious—and it goes to the very heart of the recent financial crisis,” Attorney General Eric Holder said at a news conference.
That’s impressively tough language, and it almost sounds like payback for S&P’s decision in August 2011 to downgrade the U.S. government for the first time to an AA+ rating from AAA. Holder denied there was any connection between the lawsuit and the downgrade, although Floyd Abrams, S&P’s attorney, told CNBC that the “intensity” of the DoJ investigation “significantly increased” afterwards. But the real question now is whether Holder will now follow through and force S&P to admit its wrongdoing formally, or will he follow the recent pattern by which major financial firms have been permitted to settle civil charges without admitting anything? (S&P, by the way, denied all wrongdoing in a statement, calling the lawsuit “meritless.”)
There is reason to be skeptical that the government will push too hard. Because what’s really going on in the relationship between Washington and Wall Street is this. The big ratings agencies, somewhat like the big banks, have been deemed too big or important to the financial system to fail. As a result, they continue to operate in largely the same way today. “One thing we’ve learned is we haven’t learned a damn thing from the crisis,” says Sylvain Raynes, a former Moody's executive who has been a severe critic of the ratings agencies.
This is not how capitalism is supposed to work, and the Obama administration has not done a very effective job of fixing it to date. Consider, for the sake of comparison, Arthur Andersen. The giant accounting firm ceased operation in 2002 after authorities learned that its auditors had shredded documents related to Enron's fraudulent schemes and were probably complicit in those practices. Even though the firm's felony conviction was later vacated by the Supreme Court, Arthur Andersen's name was so tarnished, and it faced so many outstanding lawsuits, that no one wanted to do business with it any longer. End of story.
Why haven't the ratings agencies suffered the fate of Arthur Andersen? Despite some moves in Congress to change their behavior—especially by Sen. Al Franken, D-Minn.—U.S. authorities are still treating the three largest agencies, Moody’s, Standard & Poor’s, and Fitch, fairly gently. The firms are basically doing business the same way, taking fat fees from the investment banks whose securities they rate. That is because they are still, essentially, quasi-governmental organizations. They continue to be anointed by the Securities and Exchange Commission as the arbiters of what is considered “investment grade”—or safe—securities appropriate for conservative investors like pension funds and insurance companies.
The prominence of these firms in the financial landscape was an ironic result of the government’s efforts to fix the system during the Great Depression. “Back in 1936, the bank regulators told banks, If you are going to buy bonds, and have them in your portfolios, those bonds cannot be speculative. They must be investment-grade. Who is the arbiter of what is speculative and investment grade? These handful of rating agencies,” said Lawrence White, a financial expert at New York University. “In essence, the bank regulators were outsourcing this safety decision. The rating agencies’ judgments secured the force of law.” Later on, in 1973, the SEC formalized the role of the ratings agencies in the system by designating them “Nationally Recognized Statistical Rating Organizations.” Only these firms could decide what was safe and unsafe.
That system worked fine in the days of ordinary corporate or municipal bonds, when the agencies’ ratings assessments were publicly available and could be checked against performance. No rater wanted to be embarrassed by being exposed giving a faulty rating. So the agencies were more immune to pressure from the investment banks to rate bad deals. But as the era of “structured finance” took off—the sort of fancy “collateralized debt obligations” named in the S&P lawsuit—debt began to get packaged and repackaged in ever-more complex bundles of securities. It became harder and harder to double-check the ratings within those bundles. Every ratings company had its own methodology; it wasn’t standardized as methods were in accounting. In the end, there was no longer any public accountability—the embarrassment of getting a rating badly wrong—to weigh against the temptation of fees from big deals from the banks.
At first subtly, then profoundly, that began to corrupt the integrity of once-respectable ratings agencies like S&P. They became vassals of the Wall Street firms they were rating, and once again, neither the Fed nor the SEC was closely watching the change. Neither the public nor even sophisticated investors could check the ratings. And barring some catastrophic market collapse—which everyone thought at the time was highly unlikely—there was almost no way for the agencies to be caught out on the derivatives deals they rated, even as they enjoyed the government’s protection.
That was the mindset four years ago. And the “issuer-pay” model—by which the banks pay the agencies to rate their securities, creating an automatic conflict of interest—is largely intact. Sure, the public may be safe for now, a time of extreme caution on Wall Street. “We don’t really know how they’re doing now with respect to mortgage-related bonds because there have been virtually none that have come to market,” says White. “And with respect to ‘plain vanilla’ corporate and sovereign-country bonds, there is never any problem. The issuer-pay model didn’t blow up in those areas.” But at some point the market will forget the last crisis, and go back into bubble mode. Unless the government is able to exact real penalties and a genuine confession of what went wrong during the 2008 financial crisis—from S&P and others—it’s entirely possible it could all happen again.