On Sept. 2, US District Court Judge Shira Scheindlin ruled that a lawsuit filed by institutional investors alleging fraud by Moody’s(MCO), S&P, and Morgan Stanley (MS) may go forward, dismissing the rating agencies’ traditional First Amendment, freedom of speech defense. MCO and McGraw-Hill (MHP), which owns S&P, declined when the ruling hit the wires, on fears that without the free speech defense the agencies could be open to unlimited legal liability.
The plaintiffs, Abu Dhabi Commercial Bank and King County, Washington (which includes Seattle) purchased notes issued by the then AAA-rated Cheyne Structured Investment Vehicle (SIV) beginning in 2004. Cheyne went bankrupt only three years later, and that bankruptcy helped spark the money market crisis of 2007.
On the face of it, the investors have cause for anger. Triple-A ratings traditionally mean, safe to buy, forget, and clip the coupons. Having a triple-A issue go bankrupt at all is an embarrassment for the agencies. Having the issue go from triple-A to bankrupt so quickly means the agencies blew the call about as badly as they possibly could. The court will decide if the blown call happened through incompetence or something worse.
Here’s another reason why I think the investors have a case: the rating agencies have access to gobs of confidential information that other investors don’t see. Their analysts can ask an issuer just about any question and get the answers they want. So the agencies ought to have known, and certainly had every resource to find out, about the flawed mortgage backed securities (MBS) that were folded into the collateralized debt obligations (CDOs) that Cheyne owned. Nonetheless the agencies stamped the junk with a triple-A.
The agencies claim that they relied on models of the housing market that didn’t allow for a nationwide decline in home prices, as opposed to a regional one. Lame as it sounds now, that model had some merit (though not that much), before, say, 2003 when mortgage lending standards started to deteriorate. But if anyone was in a position to know that the game had changed, it was the agencies. They could have demanded sample loan files to get a feel for the underlying collateral, and no doubt the investors will ask about this in court. Loan files are normally highly confidential, kept between the borrower and lender, but that is exactly the kind of thing that the rating agencies can see (and bank examiners certainly do see) but outside analysts can’t.
The agencies’ bank analysts also should have known about deteriorating home loan underwriting. After all, the agencies also rate bonds issued by banks. If I were representing the investors, I’d ask if the agencies’ bank analysts had learned about weak home loan collateral, and if they talked to the analysts in the groups who rated SIVs. You’d think that someone, somewhere in S&P or Moody’s had some idea about this. Yet they continued to bless structured products with triple-A ratings as quickly as the bonds could get cranked out.
My guess is, a fair number of people at S&P and Moody’s knew quite well that the mortgage markets had gone bad. After all, some colorful internal S&P e-mails came out in October 2008. One of them mentioned a “house of cards” and another, that “a cow could come up with this structure and we would rate it.” But who would dare raise a stink, when the agencies’ structured product groups were making the real money (more on that below)? The court will have to decide whether such general awareness in the firms evidenced fraud or not.
The deterioration in loan underwriting standards enabled the housing bubble and made a subsequent collapse almost inevitable. Back in the ‘Sixties and ‘Seventies, Fannie Mae and Freddie Mac ran large databases on loan experience through their computers, and figured out what a sound home mortgage loan looked like. From this exercise came the guidelines that many of us grew up with: 10-20% down, a maximum of 28-33% of income needed to service debt, and a stable work history, among other things.
When Fannie Mae and Freddie Mac’s standards ruled, that meant that in the nation as a whole, house prices had to be related to borrowers’ ability to pay the loans. The advent of liar loans with initial teaser rates, and similar unsound products, broke the relation between house prices and income. Therefore, at least for a time, there was almost no limit to how high prices could go. Again, the rating agencies were in as good a position as anyone to know about this problem early on.
Contrast the recent bubble to the S&L crisis in the 1980s. We did see a housing bubble in Texas, based on the energy boom and bust; there were also problems in a few other areas, notably New England. But bad as the Texas home loan problem got, it did not go national. The recession of 1990 was less severe in other parts of the country, and in any event, home prices remained tethered to borrowers’ incomes in the country as a whole. But that was your father’s home loan problem and the rating agencies are paid to know the difference.
Rating agencies have a tighter relationship with issuers of structured bonds than they do with, say, corporate bond issuers and that may be examined in this case too. In corporate bonds, the agencies heavily consider the ratios of cash flow to interest expense and other fixed charges such as capital leases when they make their bond ratings. IBM, for example can’t grow more cash flow out of thin air in order to make S&P happier. If they want to borrow money in the bond market, they give the agencies their financials and the agencies decide how strong the bond is, and that is mostly that.
But structured product issuers can do all sorts of things to make their issues stronger and get higher ratings for the top tranches. They can assign more cash flow to the top tranches, or they can increase the overcollateralization factors, to name two. So the issuers could and did rejigger a structured product until they got the rating they wanted. Meanwhile, one has to wonder: if the the agency effectively blessed the structure, are they invested in that structure? And would they be reluctant to downgrade the issue even when new information casts doubt on the issuer’s ability to repay the debt? That’s the subtle potential for conflict of interest that an agency faces when rating structured products.
The more blatant potential conflict, and Judge Scheindlin cited this in her ruling, is that structured product ratings pay the agencies about three times as much as other ratings do. So the agencies may have had at least some incentive to curry favor with the issuers of structured products — as in, give them a triple-A on the Cheyne SIV, get more SIV business next week. If that turned out to be the case, the agencies came awfully close to selling top ratings for cash.
I only wish that the ramifications of this case stopped with the rating agency business model, but they also strike at America’s influence and reputation for probity. Think of it this way: corporations — and sovereign governments around the world — care about what their bond ratings when they want to borrow money. Despite their flaws, the rating agencies provided a baseline opinion that was respected, and having institutions like those domiciled here, was one of many things that made the United States a country that others wanted to emulate. When the rating agencies fail so grossly, like it or not, it reflects on us. This is the sort of thing China and Russia talk about when they question America’s legitimacy as custodian of the world’s reserve currency. These are the sorts of things that the leading power needs to get right — or fix quickly — if it wants to stay in the lead. Which is why prompt and credible rating agency reform (and a few criminal prosecutions if evidence warranting that emerges in this case) would be a small but significant gesture that could do us a world of good.