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The Suit Against S&P - Where are the Banks?

The Department of Justice has brought a civil suit against Standard & Poor’s, the credit rating agency, that centers on the decisions that S&P made concerning models it used to evaluate default risk for mortgage-backed securities prior to the financial crisis. Default risk was central to the credit ratings assigned to the bond issues. The models calculated statistical probability of various outcomes based on historic data and many assumptions. If S&P used assumptions and model mathematics to obtain results that were designed to qualify the bond issues for desired credit ratings, presumably so that it could earn fees. The government should hold it responsible for its actions.

But, S&P and the other ratings agencies were not the only organizations connected with mortgage-backed securities that were running these types of models. In particular, the big banks that accumulated the pools of mortgages, packaged them and carved them up into structured bond issues that they sold were also running similar models. Where are the lawsuits against the big banks for selling these bond issues? New York Attorney General Schneiderman has gone after JP Morgan Chase as successor to Bear Stearns for shoddy packaging and servicing of mortgage pools. But that was done to feed the beast of these huge bond issues. Standards for selling securities to the public have to be enforced.

The big banks undoubtedly ran their own models measuring default risk. First of all, they structured the deals and then brought them to the ratings agencies. A major goal of the structuring was to design an offering that met ratings criteria so as to secure the ratings that were needed. To accomplish this, the banks had to be able to anticipate how the agencies would view the proposed structured deals.

The banks were not merely passive participants in the ratings process. Bankers generally behave as advocates for their structures, arguing their case to the agencies for the most favorable rating outcome. It is unthinkable that the banks did not engage in debates and try to influence the agencies to adjust their models to achieve favorable results. The only way to do this was for the bank to run its own models. It is very likely that the banks, with so much money at stake, employed even more sophisticated analytics than the ratings agencies.

Another reason that the banks most certainly used sophisticated models to measure risk was that they made markets for the bond issues that they underwrote and could also end up with unsold balances. They had direct exposure to the credit quality of the bonds. Of course, they could also dump inventory if things started to deteriorate. That process was illustrated with horrifying clarity in the hearings of the Senates Permanent Subcommittee on Investigations concerning Goldman Sachs, chaired by Senator Carl Levin.

If the banks knew that the models were inadequate, would they not be culpable alongside S&P? And would they not be even more culpable if they used their market power and superior analytics to influence S&P to fiddle the models to achieve an outcome?

So where are the bank defendants?

Mortgage–backed securities were immensely profitable for the banks. They made money in multiple ways from many sources. It is entirely logical that the banks understood the deficiencies of the models used to acquire ratings and engaged in a cost/benefit tradeoff. The risk of the market going south was mitigated by the profits that they earned immediately. It appears that this cost/benefit analysis did not work out for the banks, especially for those that disappeared in the crisis. But for others, the ones that got bailed out, it wasn’t such a bad outcome. Not only did they escape the worst consequences, but competition was also winnowed down to a handful of powerful mega-banks.

The mortgage-backed market was premised on statistical models. All other factors paled by comparison. It has been argued that the basic assumptions used in the models were disclosed to investors so “they got what they paid for.” But this is nonsense. The investors believed that the models were reliable because of the participants in the deal. That the ratings agencies assigned ratings was influential. But it is naïve to think that the participation of large and unbelievably sophisticated Wall Street banks was not even more influential.

Most certainly, go after the ratings agencies. But it is time that that the Justice Department addresses the core of the problem with the bond offerings: the banks who made the most from the scam.