Ratings Agencies: Still Shilling for Shillings

Magic hatThe April 19, 2014 Economist reports [Credit where credit’s due] that the ratings agencies are making a financial comeback after their near-death experience following the financial crisis, circa 2007-2009.  For those readers who believed that Moody’s, S&P, and to a lesser degree, Fitch, were pure as the wind-driven snow, let me correct the record: During the years 2005 – 2008 the ratings agencies got paid big bucks to give inflated ratings to security offerings from large investment banks so that institutional investors would pay billions of dollars to purchase them.  Many of these investments were filled to the brim with subprime mortgages.  But they were pumped and packaged in such a way as to be rated as “investment grade.”

Essentially, for a fee, the ratings agencies were prepared to hold their collective noses and allow their imprimatur to be used to pimp these CDOs [i.e. collateralized debt obligations] to hungry institutional investors chasing higher returns. For a closer look at the scam, go to my posts here and here. And perhaps the most damning indictment of this ruse-for-profit is found at pages 243 – 317 of the Levin Report, here.

So, in 2013, the Department of Justice decided to make an example out of S&P, who had foolishly decided to break from its other partners-in-crime, and downgrade America’s credit rating.[1] Although it hardly created a ripple in this country’s bond sales, the feds sued S&P for $5 billion, claiming that in the lead up to the financial crisis, it was fully aware that the bonds it was touting as spun gold, were really just straw. Needless to say, S&P complained it was being selectively prosecuted because of its downgrade.  Since then, the rhetoric has cooled, and the farther the crisis recedes from public memory, the less we’ve heard about the fact that during the heydays, the ratings agencies were really nothing more than shills for the big investment banks.

According to the article:

…in spite of these problems the “big three” agencies—Moody’s, S&P and Fitch—are now thriving again. Revenues from ratings services at all three outfits surpassed pre-crisis levels last year. Profits at Moody’s are at a record high; S&P’s are not far off. With margins at an enviable 52% and 44% of ratings revenues respectively, Moody’s and S&P now look more attractive as businesses than most other financial firms do.


The fact that issuers still pay for ratings, rather than investors, has also helped maintain demand. Companies issuing bonds benefit from getting them rated by the agencies. The return in lower borrowing costs can be up to ten times as much as the fees paid for the rating. Regulations that still make it virtually impossible to sell unrated bonds in America are also a boon.

Riddle me this Batman:  How is it that after their post-crisis effort to turn the ratings agencies into institutional piñatas, Congress now seems to have lost interest in the righteous indignation theatrically displayed during the publicly televised hearings?  The answer? Simple. Politicians change witch hunts like chameleons change color.  If polling doesn’t show that the majority of the American people are outraged, then political interest wanes.

The SEC was meant to issue new regulations about ratings agencies by May 2011, but three years later they are still yet to be finalised. Critics, such as the Consumer Federation of America, a lobby group, complain that they fail to reduce the ratings agencies’ influence as much as Congress wanted. In part, that is because it has proven much “easier said than done” to replace ratings with other indicators in risk models, according to Sam Theodore at Scope Ratings, a boutique agency.

Conclusion.  There is no question – none – that the ratings agencies were the sole enablers of the investment banks’ efforts to sell billions upon billions of securitized subprime loans. Here’s why: Fannie and Freddie initially could not sell this junk to investors, since it did not conform to the GSEs’ underwriting requirements.  As a result, investors migrated to the private label [i.e. non-GSE] secondary market for higher returns.  But the private label market needed “Wall Street Cred” i.e.  it needed some assurance that the paper was “investment grade,” which large municipal  and pension funds were legally restricted to purchase. Since the private label securities did not have the “implicit guarantee” of the federal government, as did the GSEs, something else was needed. Enter the ratings agencies, who stamped the securities as “investment grade” which, as we know today, was the cosmetic equivalent of putting lipstick on pigs.  We know this because in an implicit admission of guilt, the ratings agencies, in unison, downgraded all of their heretofore AAA rated securities to junk in the late summer of 2007.  As the financial and credit markets began to circle the drain as a result, the investment banks found that they could no longer sell the junk they were holding.  Unable to extricate themselves, Bear Stearns collapsed, Lehman Bros. filed for bankruptcy, and a host of large banks [E.g. Countrywide, Wachovia, WAMU, Merrill Lynch, etc.]  allowed themselves to be acquired for pennies on the dollar.

Given their new lease on life, I’m betting even money that the feds and S&P quietly enter into a settlement where each side publicly declares themselves the winner. And so it goes, and so it goes….

[1] If I were a fly on the wall in S&P’s boardroom, I suspect the conversation went something like this:  Chairman: “OK, everyone, this meeting is called to order.  As you know, our stock price has hit all-time lows, and our reputation now is lower than Lance Armstrong’s. What can we do to show the public that we take the ratings business seriously; that our ratings can’t be bought; that we’re not just a modern day Irma la Douce?  Voice from back of room: “I know!  Let’s downgrade the United States!  Everyone knows its credit is in the tank around the world. If they weren’t the Big Dog, they would have been downgraded years ago.”  Chairman:  “Hmmm.  Not a bad idea.  I doubt Moodys and Fitch would go along, but that’s even better.  It shows we have cajones, and are not afraid to make tough decisions.  Besides, what could possibly happen?  It’s not like we’d get sued or something.”