When Crony Capitalism Goes Bad

The government has finally found someone to blame for the mortgage meltdown: S&P, a ratings agency. But the accused says the government has other motives. [Credit: Boston Globe]

The gov­ern­ment has final­ly found some­one to blame for the mort­gage melt­down: S&P, a rat­ings agency. But the accused says the gov­ern­ment has oth­er motives. [Cred­it: Boston Globe]

What hap­pens to crony cap­i­tal­ism when things go bad­ly? Every­body lawyers up and charges and coun­ter­charges fly hard­er and faster than in a nasty divorce.

That, at least, is what’s hap­pen­ing in the most sub­stan­tial gov­ern­ment reac­tion yet to the hous­ing mar­ket melt­down: a $5 bil­lion civ­il action by the Jus­tice Depart­ment against Stan­dard and Poor’s. The gov­ern­ment alleges that S&P, which rates res­i­den­tial mort­gage-back secu­ri­ties (RMBS) and deriv­a­tives known as col­lat­er­al­ized debt oblig­a­tions (CDOs), com­mit­ted mail, wire and finan­cial insti­tu­tion fraud dur­ing the hal­cy­on days of the hous­ing bubble.

S&P’s brief, filed last week in response to the charges, includes the claim that the Jus­tice Depart­ment is pros­e­cut­ing them only because the rat­ings agency down­grad­ed its rat­ing of US Trea­sury debt. S&P stripped the US gov­ern­ment of its gold-plat­ed AAA rat­ing in 2011; none of its com­peti­tors took that step. As far as S&P is con­cerned, this whole case is an act of retal­i­a­tion by an Admin­is­tra­tion still stung by the downgrade.

The Jus­tice Depart­ment, for its part, calls the claim “pre­pos­ter­ous.”  But maybe not.

DOJ’s com­plaint begins with a recita­tion of how gov­ern­ment, rat­ings agen­cies and large finan­cial insti­tu­tions all worked togeth­er to cre­ate the dodgy mort­gage financ­ing struc­ture that gen­er­at­ed tril­lions in rev­enue before its col­lapse. Banks would orig­i­nate mort­gages, often with­out prop­er­ly assess­ing the abil­i­ty of bor­row­ers to make pay­ments. They then would sell them off, some­times to big­ger banks but more often to gov­ern­ment-spon­sored enter­pris­es, known as Fan­nie Mae and Fred­die Mac. Fan­nie, Fred­die and oth­er finan­cial insti­tu­tions would then bun­dle the mort­gages into securities.

That’s where rat­ings agen­cies came in. In exchange for fees, S&P, Moody’s and oth­er rat­ings firms would grade the bun­dle of mort­gages. Typ­i­cal­ly, an RMBS or CDO would car­ry rat­ings from at least two agen­cies. The bet­ter the rat­ing, the hap­pi­er the issuer (Fan­nie, Fred­die or a pri­vate bank) who paid for the rat­ings. Gov­ern­ment involve­ment fig­ured in here as well. In addi­tion to accred­it­ing the rat­ings agen­cies, it required that fed­er­al­ly insured banks pur­chase only “invest­ment grade” secu­ri­ties, those that got a rat­ing of at least BBB-. Reg­u­la­tions were stricter for cred­it unions, which were required to hold secu­ri­ties that received at least an AA- rat­ing from at least one rat­ings agency.  Anoth­er rea­son why issuers cov­et­ed high rat­ings from S&P and others.

This inces­tu­ous rela­tion­ship between gov­ern­ment and banks worked well for all involved. At one point, S&P had rat­ed $4 tril­lion worth of RMBS and CDOs, gen­er­at­ing sub­stan­tial rev­enue. Banks and investors also were doing well. So were bor­row­ers. Peo­ple were liv­ing in homes they couldn’t afford and ris­ing hous­ing prices were turn­ing hous­es into ATMs, as peo­ple bor­rowed against illu­so­ry equity.

But noth­ing lasts for­ev­er, par­tic­u­lar­ly when it rests on a foun­da­tion of bad cred­it. The results are well known – the col­lapse of hous­ing prices, fore­clo­sures, bank fail­ures, bailouts, reces­sion, per­sis­tent­ly high unem­ploy­ment and an econ­o­my still slog­ging through a slug­gish recov­ery. The cul­prits, it would seem, are every­where: banks who lent to peo­ple who couldn’t pay them back, bor­row­ers who took on more debt than they could han­dle, the gov­ern­ment that encour­aged and sub­si­dized such behav­ior and induced banks to load up on RMBS and CDOs, and rat­ings agen­cies who cer­ti­fied the qual­i­ty of those instruments.

But for all of that, the Jus­tice Depart­ment would have us believe that they have found the true vil­lain: S&P.

“S&P’s desire for increased rev­enue and mar­ket share in the RMBS and CDO rat­ings mar­kets led S&P to down­play and dis­re­gard the true extent of the cred­it risks posed by RMBS and CDO tranch­es in order to favor the inter­ests of large invest­ment banks and oth­ers involved in the issuance of RMBS and CDOs who select­ed S&P to pro­vide cred­it rat­ings for these tranch­es.” [pp. 2–3]

S&P, accord­ing to the gov­ern­ment, delib­er­ate­ly engaged in grade infla­tion to entice issuers like Fan­nie, Fred­die and the big invest­ment banks to pay them, rather than their com­peti­tors, to rate their securities.

In its response brief, the rat­ings agency flat­ly denied that it cooked the rat­ings to col­lect more fees than its competitors.

“S&P Rat­ings did not antic­i­pate the full speed, sever­i­ty, and breadth of the col­lapse of the hous­ing mar­ket and its impact on the econ­o­my as whole. S&P Rat­ings was not alone. Oth­er rat­ing agen­cies that have not been charged with fraud or mis­con­duct by the Unit­ed States issued rat­ings sim­i­lar to and often iden­ti­cal with those of S&P Rat­ings. Indeed, every CDO tranche cit­ed in the Com­plaint received iden­ti­cal rat­ings from S&P Rat­ings and at least one oth­er rat­ing agency.” [p. 3]

S&P notes that its rat­ings did not dif­fer from those of its com­peti­tors, sug­gest­ing that it was no more sub­jec­tive – and no less mis­tak­en — than they.  The brief also argues that the agency was not alone in fail­ing to antic­i­pate the impact and mag­ni­tude of the hous­ing mar­ket col­lapse. It reminds the Jus­tice Depart­ment that none of the par­ties that ben­e­fit­ed by help­ing inflate the hous­ing bub­ble – includ­ing its biggest abet­tors, the Trea­sury Depart­ment, the Fed­er­al Reserve, Fan­nie Mae, Fred­die Mac and a panoply of gov­ern­ment reg­u­la­tors – fore­saw its com­ing col­lapse. Then-Trea­sury Sec­re­tary Hank Paul­son said at the time that it wasn’t a “seri­ous prob­lem” and Fed­er­al Reserve Chair­man Ben Bernanke said after­ward that he nev­er saw the cri­sis com­ing.

If they missed it, why would the Jus­tice Depart­ment sin­gle out S&P for blame? Because, the brief argues, only S&P had the temer­i­ty to down­grade US gov­ern­ment debt.

“Only S&P Rat­ings down­grad­ed the Unit­ed States and only S&P Rat­ings has been sued by the Unit­ed States, even though the S&P rat­ings chal­lenged by the Unit­ed States were no dif­fer­ent than those of at least one oth­er rat­ing agency.” [p. 70]

If that sounds a bit dra­mat­ic and vague­ly implau­si­ble, the Jus­tice Department’s rebut­tal hard­ly con­vinc­ing. DOJ notes that it began its inves­ti­ga­tion of S&P in 2009. That’s true, but it didn’t file charges until Feb­ru­ary 2012, months after the agency down­grad­ed US Trea­sury debt. The down­grade was well known and wide­ly report­ed at the time. Was pres­sure put on the department’s pros­e­cu­tors to pro­ceed with a complaint?

S&P will have a dif­fi­cult time prov­ing that the DOJ act­ed improp­er­ly. That would not, of course, make S&P inno­cent of hand­ing out decep­tive­ly good rat­ings. The DOJ com­plaint is filled with alle­ga­tions that they did, alle­ga­tions that may hold up in court despite S&P’s denials. That is some­thing for the courts to sort out.

What is evi­dent is that S&P was but one crony among many in a scheme that dis­tort­ed hous­ing prices. For­tunes were made on this scheme, which depend­ed on entan­gle­ments between gov­ern­ment and big finan­cial institutions.

Had S&P reduced its rat­ings of these instru­ments when things were going well, they would like­ly have incurred the wrath, not only of the banks who were buy­ing and sell­ing the secu­ri­ties, but of the gov­ern­ment itself. Fan­nie and Fred­die would not have react­ed well to a down­grade of their finan­cial instru­ments. Nor would their reg­u­la­tor. Wall Street titans who bun­dled the secu­ri­ties also would have been enraged and looked to oth­er agen­cies to rate their secu­ri­ties, poten­tial­ly cost­ing S&P hun­dreds of mil­lions in lost fees. Com­mu­ni­ty banks and cred­it unions, who car­ried the RMBS and CDOs on their bal­ance sheets as part of their cap­i­tal reserves, would have said the S&P down­grades would impair their capac­i­ty to lend to house­holds and small busi­ness­es and lob­bied the gov­ern­ment to act.  Con­gress would have react­ed, alleg­ing that S&P was jeop­ar­diz­ing its goal of expand­ing home­own­er­ship. The polit­i­cal pres­sure on the rat­ings agency would have been enor­mous. There may even have been calls for an inves­ti­ga­tion into its rat­ings practices.

But S&P did not stray from the herd. It con­tin­ued to assign invest­ment-grade rat­ings to RMBS and CDOs that sub­se­quent­ly cratered. The gov­ern­ment says that its behav­ior was will­ful. S&P says that it was caught up in the same dynam­ic as home­own­ers, mort­gage orig­i­na­tors, invest­ment banks, gov­ern­ment-spon­sored enter­pris­es, investors, and the gov­ern­ment, includ­ing the Sec­re­tary of the Trea­sury and the Chair­man of the Fed­er­al Reserve, all of whom played impor­tant roles in cre­at­ing the bub­ble and bear a share of the blame for the sub­se­quent misery.

But admit­ting shared guilt is not how crony cap­i­tal­ism works. Once bub­bles burst, it’s every crony for him­self. The trick is to avoid blame by shift­ing it to oth­ers. Of all the cronies, gov­ern­ment bears the largest share of the blame. It also is the one insti­tu­tion with the legal author­i­ty, not only to blame oth­ers, but to brand them as criminals.

The gov­ern­ment has decid­ed to charge S&P, as though the prob­lem wasn’t with the RMBS and CDOs them­selves or the wide­spread excess that inflat­ed their val­ue, but with one of the agen­cies that, like its com­peti­tors, assigned them high rat­ings. How the Jus­tice Depart­ment arrived at this deci­sion remains a mys­tery. But it is cer­tain­ly pos­si­ble that S&P sealed its fate as a scape­goat when it down­grad­ed the government’s debt.