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Holding the ratings agencies accountable

Andrew Ross Sorkin had an interesting report today on some lawsuits meant to hold the ratings agencies responsible for the securities that they branded safe and that turned out to be dangerous.

The plaintiffs argued that the rating agencies, rather than Lehman, as listed in the offering documents “largely determined the composition of the securitized pool of loans, the amount and form of the certificates’ levels of credit enhancement before the certificates were created and the ratings agencies were ‘engaged’ to rate the securities.”

That statement was not far off the mark. The role of the rating agencies, as documented in several of these cases, shows that the firms were intimately involved in the creation of these securities, from start to finish. They didn’t simply put their Good Housekeeping Seal of Approval on them in the form of triple A-ratings. They played a big role in putting them together.

The judge in the case, Lewis Kaplan, didn’t necessarily disagree with the investors’ premise, writing in his decision that the role of the ratings agencies was “no different than those of an architect or a builder in designing and constructing a house.”

The judge eventually ruled against the investors, saying that "ultimately, the ratings agencies were not the owners of the house that was being resold to investors." Still, a good try by the plaintiffs! And a welcome reminder that rating agency reform is one of the most important elements of financial re-regulation.

For more on the role the ratings agencies played in the financial crisis, read Roger Lowenstein's great piece.

By Ezra Klein  |  February 16, 2010; 4:36 PM ET
Categories:  Financial Crisis  
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Comments

Any comments on whether Nancy Pelosi's banking buddies---the Sandler's should be liable for the toxic assets they soled to Wachovia?

Ezra?

Posted by: FastEddieO007 | February 16, 2010 4:28 PM | Report abuse

I'll be glad to see greater coverage and investigation of the role of the ratings agencies in all this -- I have always said that their behavior was an essential component in the cascade of misjudgments about risk etc (I know, who cares what I have always said, but still...)

Posted by: bdballard | February 16, 2010 5:10 PM | Report abuse

I had heard that AIG Financial Products sold "exotic financial products" using AIGs' rating. Now, of course, the financial loss for that harmless little bit of deception is being bourne by the TAXPAYERS.

In my city, those who hold up banks get arrested and go to jail when caught. Why AIG traders and associated rating agencys have not been forced to take the "perp walk" is a mystery to me.

Posted by: shadowmagician | February 16, 2010 5:50 PM | Report abuse

Financial topics always brings out the irrationality in people.

Fast Eddie- Wachovia bought Golden West with their eyes open. There was nothing shady about it- they just bought in at the very top of the bubble.


shadowmagician- if AIG stood behind the CDSs, as I believe they did, then they were right to use AIG's credit rating. There was nothing underhanded about it.

Posted by: Quant | February 16, 2010 6:09 PM | Report abuse

--"Financial topics always brings out the irrationality in people."--

No, Klein is like that all the time.

Fer instance: How does Klein suppose that someone be held accountable for pronouncing an *opinion* on the suitability of a financial instrument?

I daresay Klein's answer involves more government regulation, or perhaps a full government takeover of ratings bookmaking, because, you know, ratings are too important to be left to the hoi polloi.

But there is no magic formula for assigning hard, fast, and accurate "ratings" to the many instruments wound in the many situations, all moving at present time velocity.

The only effective way to hold ratings agencies accountable is to cut them free from government oversight and regulation and let the free market price their product on the basis of its worth. On the activity of the last few years, we might see Standard & Poors, Moody's, and Fitch all out of business, and everybody better off for it.

Posted by: msoja | February 16, 2010 7:10 PM | Report abuse

dude- are you really advocating a world without rating agencies?

Posted by: Quant | February 16, 2010 7:19 PM | Report abuse

msoja,

"Fer instance: How does Klein suppose that someone be held accountable for pronouncing an *opinion* on the suitability of a financial instrument? I daresay Klein's answer involves more government regulation, or perhaps a full government takeover of ratings bookmaking, because, you know, ratings are too important to be left to the hoi polloi.... The only effective way to hold ratings agencies accountable is to cut them free from government oversight and regulation and let the free market price their product on the basis of its worth."


So when the rating agency is being paid by the same institution whose products it rates, you really think that represents the free market pricing its product on the basis of its worth?


"But there is no magic formula for assigning hard, fast, and accurate "ratings" to the many instruments wound in the many situations, all moving at present time velocity."

Often true with highly dubious instruments, and if there is no clear formula by which an expert can determine risk, that is exactly why they should have been rated so much more conservatively...i.e., lower....i.e. "buyer beware....because there is no way to honestly calculate the risk of these particular things."

That the toxic instruments were instead rated so highly indicates a broken system that is badly in need of reform.

Posted by: Patrick_M | February 16, 2010 7:33 PM | Report abuse

--"So when the rating agency is being paid by the same institution whose products it rates, you really think that represents the free market pricing its product on the basis of its worth?"--

Would YOU pay attention to the ratings of an agency touting its own product? Why do you suppose anyone worth his salt would give credence to such an entity?

Good grief.

Posted by: msoja | February 16, 2010 7:40 PM | Report abuse

ps. All the major rating agency players are currently shielded from accountability by federal law. Their word was implicitly underwritten by the U.S. government. *THAT'S* what went wrong with the ratings agencies.

Posted by: msoja | February 16, 2010 7:42 PM | Report abuse

"Would YOU pay attention to the ratings of an agency touting its own product? Why do you suppose anyone worth his salt would give credence to such an entity?"

Well, I guess it is ok that the global economy collapsed because you can excuse the fact that major financial institutions, pension funds, etc., all over the world, were just not worth their "salt." Everyone relied on the credit rating agencies because the buyers in those markets don't have the specialized expertise to make the risk evaluation.

"ps. All the major rating agency players are currently shielded from accountability by federal law. Their word was implicitly underwritten by the U.S. government. *THAT'S* what went wrong with the ratings agencies."

p.s. Uh huh. That's a big part of what needs to be fixed. We need to see the creation of a better mechanism for rating that is completely independent, conservative in the methodology, and accountable.

Posted by: Patrick_M | February 16, 2010 8:02 PM | Report abuse

"Everyone relied" just isn't true. A great many people not worth their salt relied inadvisedly on the SEC regulated and supervised major ratings agencies. There's a word for it, and it's spelled: fools.

--"independent, conservative in the methodology, and accountable."--

Isn't that where the free market excels? How about if you sell me a rating that turns out to be bunk, you share in my loss. How about if you have a habit of selling crummy ratings I don't subscribe to your rating service?

Posted by: msoja | February 16, 2010 8:16 PM | Report abuse

Truly "free" markets require orderly access to accurate and reliable information by the traders. The credit agencies play a crucial role, especially with complex derivative securities.

Rather than "throwing out the baby with the bath water," logic dictates (except to an anarchist) that the proper course of action is to restore the integrity and credibility of rating mechanisms with a better structure to preserve and improve a service that the market itself regards as essential.

Securities that are so complex that they can't be rated should be so labeled, in order that prospective investors will understand that they are assuming a risk that is impossible to calculate, and disproportinate amounts of capital then will not flow toward excessive risk, as happened in the run-up to the Great Recession.

In my world, if we are watching a game and we find out that the referees have a conflict of interest, the solution is to replace them with referees that are fair and impartial.

In your anarchist world, the solution is to have no referees at all, and plunge the game into complete chaos.

Posted by: Patrick_M | February 17, 2010 12:44 AM | Report abuse

--"Securities that are so complex that they can't be rated should be [blah] [blah] [blah] "--

Who gets to decide that? Bawney Fwank?

You still don't get it: Ratings are opinions. You can't turn them into something else just by passing a law. What you're talking about is utter nonsense. Complete and utter nonsense.

Posted by: msoja | February 17, 2010 8:41 AM | Report abuse

Tea Bag handbook, page 12:

"When you run out of things to say, mock Barney Frank."

Posted by: Patrick_M | February 17, 2010 11:24 AM | Report abuse

--"Tea Bag handbook, page 12:"--

Commie two step: Change the subject.

You didn't answer the question that YOU begged: Who gets to decide which securities are so complex that they can't be rated? Bonus question: What criteria do they use?

Posted by: msoja | February 17, 2010 11:39 AM | Report abuse

"You didn't answer the question that YOU begged: Who gets to decide which securities are so complex that they can't be rated?"

Easy. The newly independent rating agency. You made the argument already that certain instruments are so complex that any rating is entirely ephemeral. Whenever that is the case, they should say so.


"Bonus question: What criteria do they use?"

The models that already exist. We know from the investigations that have already taken place that people inside the rating agencies complained to their superiors that derivatives based on sliced and diced sub-prime mortgages could not fit into any existing models for calculating risk, and thus should be downgraded or not rated at all. But such opinions were over-ruled because of the agencies' self-interest in maintaining their revenue stream from the institutions whose instruments they rate.

Restoring integrity and credibility to the credit rating services is not rocket science. An independent audit is also "just an opinion," by your definition. But it is a vey important opinion to the interested parties, and so they want some confidence that the audit is, in fact, independent.

Posted by: Patrick_M | February 17, 2010 12:17 PM | Report abuse

--"The newly independent rating agency."--

And who would that be? If a creation of government, then you don't know what "independent" means. If a creature of the free market, you've been blathering for nothing.

--"The models that already exist."--

Markets and vehicles are not static. Your solution is buggy whipism, but that's always been collectivism's forte.

Posted by: msoja | February 17, 2010 1:29 PM | Report abuse

--"We know from the investigations that have already taken place that people inside the rating agencies complained to their superiors that derivatives based on sliced and diced sub-prime mortgages could not fit into any existing models for calculating risk, and thus should be downgraded or not rated at all. "--

For what it's worth, just to further point out what nonsense you're spewing, you could replace "rating agencies" above with "SEC" (you know, the "independent" regulatory body overseeing the rating agencies) and the statement would still be true. The government experts at the SEC, the very people charged with the exact mission you want to give to some "newly independent rating agency" failed miserably to catch that which you are so fascinated with in hindsight.

Posted by: msoja | February 17, 2010 1:52 PM | Report abuse

"The government experts at the SEC, the very people charged with the exact mission you want to give to some "newly independent rating agency" failed miserably to catch that which you are so fascinated with in hindsight."

I am pleased that you do agree with the obvious fact that the past laws and SEC rules concerning the credit rating agencies have proven to be inadequate.

If you live in a residential neighborhood where motorists routinely drive faster than the legal limit and kill children playing in the streets, is the solution to abolish the posted speed limits altogether, or to put in some additional stop signs and beef up enforcement and penalties?

I'd guess that to suggest the latter course of action would be considered as spewing nonsense in Anarchyville.

Posted by: Patrick_M | February 17, 2010 3:35 PM | Report abuse

--"past laws and SEC rules concerning the credit rating agencies have proven to be inadequate."--

Yes, we need laws and SEC-like rules prohibiting behavior that turns out to be reckless in hindsight. What a clever boy you are.

--"where motorists routinely drive faster than the legal limit and kill children"--

Ah, the extreme example. Yes, make criminals of everyone in the hope that a real criminal won't break out of the pack, and when one inevitably does, impose even more penalties and onuses on those non-reckless, responsible adults.

Posted by: msoja | February 17, 2010 10:01 PM | Report abuse

"Yes, we need laws and SEC-like rules prohibiting behavior that turns out to be reckless in hindsight. What a clever boy you are."

If you knew the first thing about this issue, you would already know that there was agitation within the market, in the SEC, and even in the Bush administration, about the flaws in the credit rating agency system, well before the meltdown.

"Ah, the extreme example. Yes, make criminals of everyone in the hope that a real criminal won't break out of the pack, and when one inevitably does, impose even more penalties and onuses on those non-reckless, responsible adults."

You get ever more incoherent. With the credit agencies and with my example of the speeding motorists in the residential neighborhood, the regulations do not "impose even more penalties and onuses on those non-reckless, responsible adults," they simply discourage reckless and injurious behavior by bad actors.

It may not very popular to regulate against reckless and injurious behavior on the streets of Anarchy-ville, but most civilized "streets" benefit from the value of a few rules of the road - even Wall Street.

Posted by: Patrick_M | February 18, 2010 12:46 AM | Report abuse

--"flaws in the credit rating agency system"--

Once again, you cannot legislate perfection into what is at base the art of prognostication. Alternately, if you do manage to, by use of overt government force, remove all RISK from the economy, you won't have an economy. All endeavor, all progress, carries with it an element of RISK. We do not live in some imaginary riskless universe, contrary to what you seem to believe. And people WANT to bet their abilities against the vagaries of the world, and it is that base risk taking, out of which success is built.

You can put stop signs and traffic lights and surveillance cameras on every street corner in the country, and it might be very safe, but no one will be able to drive anywhere.

It's nonsense. You are nonsensical.

Posted by: msoja | February 18, 2010 12:24 PM | Report abuse

Did I ever say anyone can "legislate perfection?" or "remove all RISK from the economy?"

No.

But risk can be (imperfectly) measured and reduced. That's why intelligent buyers have an independent inspection when they buy a home or a pre-owned automobile. Because (again) risk can be (imperfectly) measured and reduced.

"Nonsensical" thinking I know.

Posted by: Patrick_M | February 18, 2010 3:23 PM | Report abuse

--"But risk can be (imperfectly) measured and reduced."--

And only government can do it. Like they do with the already incomptently functioning SEC, and umpteen other buffoon regulatory agencies. And we're not heading into a depression because they performed their functions so well. Oh, but sure, if we had just amended clause C in subsection eleventy nine, none of those horrible risks still being pushed by Fannie Mae and Freddie Mac would EVER have come to horrible fruition. Just one more clause (and two more threats of incarceration, except for policy writers, of course!)

There's no way to slice it that it isn't nonsense, Patrick. In the generic sort of handwaving you perform it all sounds SO reasonable, so rational, so doable, until you actually go around and try to figure out what it is that people should be doing differently when push comes to shove. "Oh, I'm afraid that Acme subordinated stock should have a rating of CCC- and a half instead of CCC-, off to jail with you, you flaming criminal!!!"

And, of course, people like you want to be able to just go to sleep, and should the need arise to ever invest in anything, you can look up your guaranteed rate of return in the Sunday Government Funny Papers and place your order accordingly, and you'll get something like 40 cents back on every dollar sent off, until Senator Bozo changes the law and takes another nickel from you.

Good luck with it all. Next year you and Klein can sit down and figure out what foods are good for us, or else, too.

Posted by: msoja | February 18, 2010 6:02 PM | Report abuse

Right. "Klein" and I want to put you in jail for eating the wrong food.

Posted by: Patrick_M | February 18, 2010 7:14 PM | Report abuse

Furthermore, Patrick_M, you might have a gander at the second link dim Klein provided. I bet even you can tease the real story out of the seven pages:

"Two key questions are whether the credit agencies — which benefit from a unique series of government charters — enjoy too much official protection and whether their judgment was tainted."

"Government responded [to the collapse of Penn Central]. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody’s 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three — S.&P., Moody’s and Fitch."

"Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the ’80s and ’90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.

"Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling “licenses” to borrowers. Indeed, whether their opinions were accurate no longer mattered so much."

"Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions."
//end excerpts

See the nonsense, Patrick? See it?

Posted by: msoja | February 18, 2010 7:16 PM | Report abuse

"See the nonsense, Patrick? See it?"

First, I am very glad you finally got around to reading the material you have been commenting about for the past couple of days.

Second, I am surprised that you now think an issue is automatically settled by an idea that is mentioned in an article that Ezra shares with his readers. I assume you are also in full agreement with all the other ideas in all the other Ezra-linked articles from Paul Krugman and others? -- "See it?"

Finally, yes, virtually everyone who has written about the problems with the credit rating agencies mentions the possibility of simply no longer having investors rely on the ratings and instead do more of their own research. However, most financial experts find that option problematic and unrealistic because of the simple fact that investors still want a common set of benchmarks and do not have the resources to do their own research on every instrument available in the market.

There is also the consideration that (for example) often the buyer of a rated bond is a mutual fund manager or pension fund manager, who is trading on behalf of many customers. Given the prevelance of the funds, industry-accepted risk ratings lend a sense of order and stability to the marketplace, up and down the ladder.

And despite its imperfections, the credit rating agency system has worked reasonably well over time, so traders would rather see the existing system of private rating services preserved and improved instead of being junked altogether, as you advocate.

Nobody is saying "only government can do it" or talking about jailing bad raters. There are a variety of proposed models that would preserve the private raters, but fund them differently and assign the instruments out to the private agencies in a different way, improving neutrality and accountability.

"And we're not heading into a depression because they performed their functions so well."

I agree with you. We are in this mess because of the repeal of common sense banking regulations (like Glass Steagle) at the beginning of the decade that quickly unleashed so much wonderful innovation and creativity in the financial sector, leading us quickly into the collapse of 2008.

Bye.

Posted by: Patrick_M | February 18, 2010 11:07 PM | Report abuse

--"However, most financial experts find that option problematic and unrealistic because of the simple fact that investors still want a common set of benchmarks and do not have the resources to do their own research on every instrument available in the market."--

You've brought it back to the absurdity of trying to build a computer from scratch. Get the government out of the ratings business and the service will flourish, with excellence rising to the top of the heap. And all without the harmful meddling of busybodies (who are the real curse of this world.)

Read the excerpts I pulled again (I'm sure Klein doesn't understand them, either, because he's the biggest moron here) and note how it was the government distortion of the ratings service that made the ratings agencies the jokes they are today. Unless the government cuts them free, they will continue to be jokes, no matter what else outside that that the government does.

*Every* government intrusion has the same effect. It's not rocket science, but there sure are a lot of people who can't wrap their tiny minds around it. Once you get it, though, it's obvious.

You ought to give it a shot, Patrick. Try thinking "freedom", "can do", "self reliance", "American ingenuity".

If that doesn't work, try to imagine Dubya Boosh, or Satan Cheney telling you what security the bank (where your accounts are) can or cannot buy.

Posted by: msoja | February 19, 2010 12:17 AM | Report abuse

The Cato Institute has an excellent article on the failure of the meddlers:

http://www.cato.org/pubs/policy_report/v32n1/cpr32n1-1.html

Posted by: msoja | February 19, 2010 12:06 PM | Report abuse

An excerpt from the link above:

The regulators seem to have been as ignorant of the implications of the relevant regulations as the bankers were. The SEC trusted the three rating agencies to continue their reliable performance even after its own 1975 ruling protected them from the market competition that had made their ratings reliable. Nearly everyone, from Alan Greenspan and Ben Bernanke on down, seemed to be ignorant of the various regulations that were pumping up house prices and pushing down lending standards. And the FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision, in promulgating one of those regulations, trusted the three rating companies when they decided that these companies' AA and AAA ratings would be the basis of the immense capital relief that the Recourse Rule conferred on investment-bank-issued mortgage-backed securities. Did the four regulatory bodies that issued the Recourse Rule know that the rating agencies on which they were placing such heavy reliance were an SEC-created oligopoly, with all that this implies? If you read the Recourse Rule, you will find that the answer is no. Like the Bank for International Settlements (BIS), which later studied whether to extend this American innovation to the rest of the world in the form of Basel II (which it did, in 2006), the Recourse Rule wrongly says that the rating agencies are subject to "market discipline."

Posted by: msoja | February 19, 2010 12:11 PM | Report abuse

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