Eric Holder and his team announced a $1.4 billion settlement with Standard & Poor’s regarding its ratings of mortgage backed securities and its role in the crash of 2008. There is no question of the venality that dictated behavior at S&P and probably the other major rating agency, Moody’s. The financial and econometric models used by S&P were allowed to yield rosier results and to ignore risks despite internal concerns, and a major motivator was the drive to maintain market share in the massive mortgage marketplace.
This piece is not intended to underscore and rehash the bad behavior of the ratings agencies. Others can pound on that drum. They were clearly lacking in principle and gave in to the lure of wealth. But, this piece is intended to make sure that we do not lose track of the fact that the behavior of the banks and other principals in the trading markets was much worse and was, indeed, at the root of the ratings fiasco.
When I was in the business of structuring deals and taking them to the ratings agencies for assessment, I learned a great deal about the relationships among investors, banks and the agencies. From that experience, I believe that I can understand how some of the well-intended proposals to address ratings may miss the mark.
The first thing that comes to mind is the immense power that the banks have over the ratings agencies. To put this into context, one must get the picture of how ratings fit in. The direct beneficiaries of ratings are investors. For some institutional investors, their organizational documents require two ratings. But even if there is no requirement, the investors want the ratings because they constitute a third party assessment of the quality of the investment. This makes the investment easier to liquidate if necessary or desired with predictable results. In other words, investments are more liquid, a characteristic that investors value.
This means that there is also value if the ratings are both credible and provided by known and widely accepted entities. If they are, the investment will be more liquid because of predictability. This has two consequences. First, investments typically have two ratings. If two agencies agree, each enhances the credibility of the other. If they disagree, the reasons could be important. The second consequence is that investors want uniformity so that the number of rating agencies will be kept to a minimum. There are strong forces favoring a sort of oligopoly in the world of credit ratings. While competition might lead to lower costs of a rating, the simple truth in a marketplace dominated by large transactions is that the cost is not of much consequence, or at least not enough to stray from the oligopoly.
There are only three agencies that matter, and one of them, Fitch, is clearly the third that sometimes replaces one of the big two but also keeps them honest. Fitch does some excellent work, but like S&P and Moody’s they have a role in the ratings oligopoly. This configuration works for investors. With two ratings in a three agency world, everything will have at least one rating by S&P or Moody’s, and Fitch is a very credible alternate, even if somewhat less prevalent.
A great deal has been made about the fact that issuers paid for the ratings and, in the mortgage market, the issuers were synthetic entities created by the banks. That has never seemed like such a large factor to me. The investors were the source of demand for the ratings and the oligopoly arose from their needs. Regardless of who paid, the ratings agency fees came out of the deal. If the investors paid, that just meant that they would pay less for the bonds. Sure there was little or no price competition, but that was because of rational choices made by investors. Maybe pricing could be affected by the banks paying the fees, but it was probably marginal.
What is less talked about is the power of the banks over the ratings agencies, especially in the mortgage backed securities markets. It is so important to remember that the primary beneficiaries for this synthetic structured market were the banks. They sold the debt and they had an obligation to disclose the quality of the product to purchasers. The banks also had greater ability to understand that the bonds were risky than the ratings agencies did. They constructed the offerings, after all. And they also had massive analytic capability. Only the banks had the practical ability to call out mistakes by the agencies.
The ratings agencies were culpable, but they were members of the “gang” not its leaders. The credit ratings agencies became partners in the process because they made more money if more bonds were issued. If more structures were rated highly, more bonds could be issued and the whole pie grew. The banks were happy with more bonds to underwrite and trade; the investors were happy to get higher yields on risks that were judged to be close to government quality; and the agencies got to charge fees on more deals.
One other factor that cannot be ignored is that the bankers undoubtedly viewed the ratings agencies as the adversaries in the ratings process. The bankers likely pounded on the agencies over every cell in the computer models to get a better result. At least that is how the process was approached when I participated. And this can be quite effective if the rating analyst wants nothing more than to become an investment banker.
The way to solve the problem lies with the banks. They should never be permitted to be both underwriter and issuer in any transaction. They should also take responsibility for the integrity of any data behind ratings and certify that they know of no issues with the models used by the ratings agencies. More than anything else, they should be held responsible for their misdeeds. This cannot be solved by trying to introduce completion. Regulating the ratings agencies is a good, they should be treated like utilities. But the only real solution is to prevent the banks from doing this kind of business and hold them responsible when it goes off track.