![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]](https://i0.wp.com/www.dougsbriefcase.com/blog/wp-content/uploads/2013/09/Credit-Boston-Globe.jpg)
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]
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.