Walt Laws−MacDonald | Show Me The Money!
Published: Wednesday, February 13, 2013
Updated: Wednesday, February 13, 2013 00:02
The Justice Department announced last week that it was planning to sue Standard & Poor’s, one of Wall Street’s largest rating agencies, for fraud — fudging ratings — during the collapse of the financial system in the late 2000s.
Ratings agencies make their money by rating things — crazy, I know. These “things” are financial instruments of all types, from the “simple” — corporate bonds, sovereign debt, loans — to the more complex −− bundles of loans, bundles of bundles of loans. They also rate things that you probably never knew could — or needed — to be rated, like “deals” and life insurance.
Investors can put their money into each one of these instruments; a bank can hold a home loan, a hedge fund can hold a bundle of loans, and a private equity firm can put their money into a buyout. Each one comes with a certain amount of risk and reward. Take a mortgage for example: the reward is the monthly payment of the price of the house, and the risk is that the homeowner will not be able to pay and have to default on the loan.
Ratings agencies provide a sort of standardized gauge of this risk−reward payoff. The safest investments — say, a treasury bill guaranteed by the United States government — have little risk and little reward. These investments are given high ratings. A similar loan made by the Greek government, however, has a much greater risk — because Athens could totally fall, like, tomorrow — and is given a lower rating, differentiating it as a riskier investment.
But these ratings agencies deal with an inherent conflict of interest in their business. Wall Street generally relies on the “Big Three” ratings agencies to rate these financial instruments: Standard & Poor’s, Moody’s and Fitch. Typically, higher−rated investments draw more investors as they provide a safer source of income. Now, let’s say a bank puts together an investment package with some risky assets and some safer ones.
They go to each agency and receive an “A” rating from S&P, a “B” from Moody’s, and a “C” from Fitch. The next time that bank needs an investment package rated, they’ll only take it to S&P because they know they will give it a higher rating than the other two firms.
This competition between firms creates an incentive for each firm to rate an investment higher than it really should be rated. If Moody’s rates the package an “A” instead of a “B,” the bank could sell it to more clients and make more money. Since the ratings agencies make money off how many of these instruments they rate, it makes sense for them to draw in more business by fudging their ratings a bit.
Essentially, Standard & Poor’s made them believe their money was far safer than it really was, rather than warning investors of how risky their assets were. Recent reports point out that Standard & Poor’s was only trying to “catch up” to the artificially−high ratings Moody’s gave out at the same time.
Though the ratings agencies have taken the brunt of the fallout for their mishandling of this competition, the real problem here is everyone’s favorite — people still say this, right? — Johnny−come−lately: the Securities and Exchanges Commission (SEC).
The SEC deemed both Standard & Poor’s and Moody’s as “nationally recognized statistical rating organizations” — basically saying that their ratings were trustworthy enough that pension funds and other large investment firms could depend on them.
To oversimplify, everyone was wrong — but with no major repercussions coming out of any of these cases, the general consensus seems to be “Yeah, we messed up ... but so did you, so why bother?” Hurray accountability!