"The Revenge of the Ratings Agencies": This Is Extortion

Monday, I wrote about how Standard & Poor's (S&P) downgrade of U.S. debt had political motivations--avoiding fraud investigations as well as 'convincing' the Securities and Exchange Commission to remove new regulations that could undercut their business:

...I won't rule out that S&P is stupid incompetent and ideologically blinkered. But they routinely commit fraud (and I'm certain if other states investigated, they would find the same thing). They are attempting to bully the American people to prevent an investigation into the role in the housing crisis, as well as preserve their business model by forestalling the new SEC regulations.

This is what frauds do. And by issuing these ratings, they can now claim, as they have already done before, that any investigations are 'revenge.'

Apparently, I'm not the only one. In Wednesday's NY Times (and why read the Times? I told you this sooner! I kid. Sorta.), law professor Jeffrey Manns writes (italics mine):

Since the 1970s, federal statutes and regulations have mandated that debt issuers obtain ratings as evidence of creditworthiness. An oligopoly of rating agencies used this authority to effectively control access to the financial system. Even a threat of a downgrade from a rating agency could cause credit to dry up, and few inside or outside of Washington dared to challenge their dominance.

The financial crisis jeopardized the agencies' privileged position. Politicians and pundits accused them of being asleep at the wheel, if not complicit with issuers, in camouflaging risks and misleading investors during the run-up to the subprime mortgage crisis. The Dodd-Frank Wall Street reform law, enacted a year ago but not fully implemented yet, threatened to introduce unprecedented oversight and regulation.

The law called for exposing rating agencies to civil liability in securities lawsuits if their ratings were inaccurate. It also challenged the oligopoly's dominance by calling for the Securities and Exchange Commission to explore the feasibility of having an independent organization select rating agencies for asset-backed securities, instead of having the bond issuers select and pay the agencies, as they now do.

The last part is key, and something I didn't really get into in my previous post on this subject. The rating agency is hired directly by the bond issuer (if it's a public municipal bond, by the local government). This results in two conflicts-of-interest. The first, described by Manns, is that if a corporation routinely issues bonds, a bad rating (even if legitimate) will convince the corporation to shop around for a more lenient rating agency. So the ratings are not very useful for bond purchasers.

The second conflict, which manifests itself in the municipal bond ratings scam, is that rating agencies have long-term financial-customer relationships with the bond insurance companies. It is in S&P's interest to push business towards the bond insurers by issuing lower ratings (as the bond insurers have admitted--only after subpoena), since the bond insurers hire these same rating agencies to rate the bond insurers themselves.

So the rating agencies aren't happy if they can't use their clout to help favored clients--and drive business to themselves. Thus, much anger at the SEC, and, by extension, the Obama administration (an aside: is the Obama administration really so naive as to not have seen this coming? Disturbingly, the answer might actually be yes). OK, back to Manns:

But the rating agencies struck back, first through civil disobedience. To evade potential liability, they threatened to freeze the markets for asset-backed securities by refusing to allow their ratings to be quoted in S.E.C. filings. The S.E.C. quickly caved and suspended the rule. Meanwhile, the rating agencies have begun a guerrilla campaign of behind-the-scenes lobbying to weaken the commission's efforts to carry out other parts of Dodd-Frank.

The S.& P. downgrade has elevated this simmering standoff to an overt clash. Politicians will be tempted to wave a white flag by granting the agencies a pass from tough regulation in exchange for the agencies' not downgrading federal debt further. While that approach may give the United States breathing room in the short run, the government should not give in to such extortion.

No, the government should not give into extortion. But this is the Obama Administration and they rollover for everybody (except liberal bloggers. Gotta punch a Dirty Hippie in the Face!). So they probably will give in.

Related: Yves Smith has more.