Two weeks ago, Standard & Poor’s put out a press release: The credit rating agency warned it was poised to downgrade almost 1,200 complex mortgage securities.
So what? Isn’t that dog-bites-man at this point?
Well, two-thirds of these mortgage bonds were rated only last year, long after the financial crisis. And S&P was supposed to have taken the distress of the housing crash and credit crisis into account when it assessed them. But in December, the ratings agency admitted that it had made methodological mistakes, including not understanding who would get interest payments when.
As everyone knows by now, the credit ratings agencies played an enormous role in creating the conditions that led to the financial crisis. Their willingness to slap Triple A ratings on all manner of Wall Street- engineered mortgage rot was enormously lucrative for the raters but a disaster for the global economy.
Unfortunately, as the episode in December shows, the credit ratings agencies are still struggling to get it right. These likely downgrades arose in a small corner of the market called “re-remics.” What you need to know about them is that they were do-overs. Wall Street took bonds that had collapsed (and which the agencies had mis-rated the first time) and re-bundled them again. Generally, the top half was rated Triple A, supposedly exceedingly safe.
The agencies rated billions of dollars worth of these bonds, mostly just in the last two years. With shocking rapidity, even some of those Triple As have defaulted.
The lesson is that the agencies are still susceptible to problems that plagued them before the crisis. “What we’ve seen in re-remics truly does encapsulate everything that was wrong not just with ratings agencies, but with banking system as a whole prior to the boom," says Eric Kolchinsky, a former Moody’s executive who tried to blow the whistle on ratings problems at the firm.
During the mortgage securities boom, bankers knew more about their bonds than the ratings agencies and took advantage. A similar problem occurred here. “Chances are that if a bond is getting re-remicked, it’s a bad bond and the holder wants to forestall the inevitable reckoning,” says Kolchinsky. The ratings agencies somehow missed that.
There also looks to have been “ratings shopping,” in which issuers seek out the most lenient firms, rather than the best. S&P, according to Kolchinsky, was slower to downgrade residential mortgages than Moody’s. Lo and behold, it nabbed the bigger market share in new offerings of residential securities. And then it had the big debacle.
An S&P spokesman didn’t respond to a question about the ratings shopping issue. In an email, he said: “A great deal has changed at S&P over the course of the past three years. We have significantly strengthened the ratings process.” One new aspect, he pointed out, is that the firm now has a policy to correct errors publicly.
The state of the ratings agencies might be less worrisome if effective regulatory oversight were coming. Unfortunately, the Dodd-Frank reforms of credit ratings are in limbo.
Here’s the problem: Credit rating companies have long contended that their conclusions are protected by the First Amendment, much as if their ratings were as irrelevant to the markets as, say, your average financial column. Dodd-Frank tried to change that, designating the agencies “experts,” just like lawyers or accountants, when their ratings were included in S.E.C. documents for certain kinds of offerings. That would make them liable for material errors and omissions in their ratings.
But the agencies revolted. They refused to allow their ratings to be used in offering circulars, freezing up the markets. Panicked, the S.E.C. immediately suspended the rule for six months, pending more study. Then in late November, the SEC extended the delay indefinitely.
“For ratings reform to be successful it needs to provide incentives for rating agencies to be objective. The Dodd-Frank Act achieves some of that, but absent the legal liability, or accountability, it’s much weaker,” says Gene Phillips, a former Moody’s analyst who runs a ratings consulting firm.
So much for that. And the news gets worse. In early December, the SEC issued an obscure notice that it doesn’t have the money to implement big parts of the Dodd-Frank reforms. And now that Republicans have taken over the House, the SEC’s budget for fiscal 2011 (which started back in October) is an even greater question mark.
One thing on hold: Creating the “Office of Credit Ratings” to oversee the powerful firms.
This office could wield enormous influence. You see, Dodd-Frank tabled many of the most important ratings agencies controversies, pending studies of the issues. If the S.E.C actually produces the zillions of reports it’s supposed to over the next several years, every employee should be awarded an honorary Ph. D.
But since the S.E.C. can’t afford to create the office in the first place, we’ll probably still be waiting by the time the next crisis hits. Meanwhile, the agencies’ rubber stamp factories are humming, much to the delight of those on Wall Street with very short memories or very deep pockets.