The Obama administration’s suit against the rating agency Standard & Poor’s makes for riveting headlines and lousy history. We want to blame the financial crisis and Great Recession on greed and dishonesty. The charge that S&P rigged bond ratings for its own gain — providing artificially high ratings on the mortgage-backed securities that inflated the credit bubble — fits this self-serving morality tale. The discomforting reality is that the financial collapse resulted from an extended period of prosperity, which led to weakened credit standards and inspired wishful thinking about the permanence of economic growth.
The administration is asking “in excess of $5 billion” in penalties from S&P, an amount it says reflects the losses caused by the erroneous ratings. Law professor Jeffrey Manns of George Washington University notes that the top three ratings agencies (S&P, Moody’s and Fitch) provide 96 percent of all ratings. A $5 billion penalty might put S&P’s parent company, McGraw-Hill, into bankruptcy and force S&P to close. A swarm of state lawsuits compounds the possibility. With many bonds rated by two agencies, Manns wonders whether it would be good public policy to convert the existing oligopoly into an effective monopoly.
Robert J. Samuelson
Samuelson writes a weekly column on economics.
The stakes here are enormous. After reviewing 20,000 pages of documents and e-mails from S&P, the Justice Department says that S&P hyped ratings of residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) to generate business. Banks and investment banks selling the securities pay for the ratings; higher ratings would attract more buyers. So S&P delayed introducing new risk models that would have lowered ratings, says Justice. S&P’s advice was not “independent” as claimed but was tainted by the pursuit of profits. Each CDO rating fetched fees from $500,000 to $750,000.
S&P calls the complaint one-sided. Hardly anyone, S&P says, anticipated the devastating crisis. The initial ratings were mirrored by other agencies. As mortgage delinquencies rose, ratings were revised. In 2006, S&P downgraded 400 RMBS ratings.
The suit reflects the conspiracy theory of the crisis: Sleazy bankers, waving distorted ratings, sold overvalued RMBS and CDOs to unsophisticated investors. It’s a seductive story contradicted by the facts. As Bloomberg columnist Jonathan Weil has written, many banks and investment banks that sold these bonds also bought them for their own portfolios. They thought the bonds had value. These included Citigroup, Merrill Lynch and Bank of America. By mid-2008, the 20 most exposed financial institutions had suffered nearly $300 billion in losses, according to Bloomberg.
It wasn’t just bankers who misjudged mortgages. So did global banking regulators. Under the so-called Basel rules, banks are required to hold $8 in capital for every $100 in ordinary consumer and business loans. (Capital is a buffer against losses.) But residential mortgages were considered sufficiently safe to justify a requirement half that — $4 per $100 loaned. These rules remain in effect.