The Credit Rating Agencies Scandal

October 21, 2008

The business practice in credit ratings is not new, but it is now getting the attention it deserves. The ratings agencies are the individuals who allowed the distribution of the subprime mortgage bonds around the world that would not have been purchased, certainly not at the price they were purchased and with the limited collateral, without the triple-A rating that they received. We are now on the other side of a derivatives experiment gone haywire, and finding out that the ratings agencies, Standard and Poor’s, Moody’s, and Fitch, who are the arbiters of credit, abetted the crime by taking money to falsify the credit-worthiness of debt instruments sold to the public. Moreover, the politicians allowed all kinds of rules and regulations to go unenforced.

Congress and the SEC required that the riskiness of debt instruments be rated by those ratings agencies, but then did no oversight or regulation. There is more regulation of slot machines in Vegas than of debt instruments, so the ratings agencies set up a model for marking prices to market that made the sales of the instruments highly profitable for themselves, but ratings were unsupported by the underlying collateral. Since the ratings agencies were paid by the issuers of the debt as well as by the financial engineers of derivatives, they were motivated to chase more business by faking ratings. The agencies not only failed to flag problems, but they gave triple-A ratings to securities which were anything but triple A.

Lawmakers spent much of today trying to sort through the aftermath of the Wall Street crisis. They’re trying to better understand how credit agencies contributed to the mess. Today’s testimony before Congress shows that the ratings agencies knew they were knowingly running a scam, and the SEC did nothing to protect the public from the falsification. Nobody looked at the models the ratings agencies use to mark the debt to market.

In today's hearing before the House Oversight Committee, the credit rating agencies looked more like profit-hungry institutions that would give any deal their blessing for the right price, reports CNBC’s Scott Cohn. Here's an example from the testimony. This is an instant message exchange between two unidentified Standard & Poor’s officials about a mortgage backed security deal on 4/5/2007:

“Official #1: Btw that deal is ridiculous.

Official #2: I know right...model def does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it [as long as they pay us].”

It is clear from this testimony that the people inside the ratings agencies knew that the underlying securities were fraudulent, but when they asked about the illegitimacy of the ratings, they were told to rate it anyway. Also from the testimony, here's a note from an S&P employee who says: "Let's hope we are all wealthy and retired by the time this house of cards falters." This is beyond conflict of interest, it is fraud, not to mention that Lehman Brothers and the Bear Stearns, who concocted these things and paid Moody’s and Standard and Poor to rate them, were able to bonus themselves hundreds of millions of dollars while there are no student loans---and retirement accounts loaded with Wamu and Lehman have been obliterated.

So while Main Street believed that the ratings were on the level, no one inside the ratings agencies ever believed the paper was triple-A. People have always trusted the ratings agencies because we have been told we could trust them; with the government’s imprimatur, they were the gatekeepers of the financial industry whom everyone trusted to rate truthfully, but they betrayed the trust.

It is the end of the financial world. The big fear is that once we unwind all of this we will see that people have sold essentially the same worthless financial assets repeatedly until the point at which we have seized the entire credit markets and frozen the entire retail macro-economic world----isn’t that the end of the game? “The ratings agencies are bringing down the entire globe,” exclaimed an irate Jeff Macke. “Today’s testimony before Congress raises the suggestion that nothing out there is what it seems. And if you think this is just a Wall Street problem, you’re wrong.”

It is going to be a long period of time until one bank will willingly lend money to another bank, a long period of time before a bank lends money to a prospective buyer. Dennis Gartman said today: A cat who sits upon a hot stove will not again sit upon a hot stove e again, nor upon a cold one either, because they all look hot to him.

This isn’t going away for a long time, every one will be reluctant for a long time. It annihilates fundamental confidence in the entire retail investment community, which has been decimated & it is going to be years before any sense of confidence returns to a new generation. This financial meltdown has done real damage to the investment psyche of America and the world, and to real economies.

The stuff they rated permeates the entire system; it is everywhere, no one can escape it. The United States is, in dollar terms, bankrupt. There are $800 trillion dollars in these derivatives floating around in the markets, they are in balance sheets everywhere, in pension funds, hedge funds, bond funds, government agency paper, IRAs, etc. That is 10 times the gross national product of the world. These dollar-denominated paper assets are likely worthless or close to it, which means that the dollar is already effectively worthless. This country is in serious trouble (that no one will tell you about). It is stupefying how a once-mighty and wealthy nation has been brought down by a slick, Wall Street con. In dismantling our industrial base and shipping jobs overseas, we unwittingly allowed the financial industry to fill the economic void, to mushroom to uncontrollable size and overweaning power and, without regulation, gave financial engineers unlimited opportunities for self-dealing. It is in the nature of homo sapiens to do that, so we should have been on the vigilant lookout. A few ruin it for all. I am sure that this is what the other species on earth would say about us, if they could speak.

In putting their profits first, the gatekeepers of the securities industry have infected the worldwide financial system. This is different from Enron because these ratings agencies were playing with the whole economy, but the nature of the corruption is qualitatively the same. Corporate debt markets around the world are a mess, a horrible world gone wrong, a global systemic infection wrought from edacious human avarice. I cannot stop thinking that this is not what we are supposed to be doing with the world, with our one sojourn on the earth.

*****

Testifying before the House Oversight Committee tomorrow, Wednesday, October 22, 2008, will be SEC Chairman Christopher Cox, who approved 40:1 leverage at the request of now Treasury Secretary Henry Paulson, formerly CEO of Goldman Sachs, and Alan Greenspan, former Chairman of the Federal Reserve, who, after 9/11, kept interest rates too low for too long.