Last week, some familiar-sounding news rocked the financial world. The Securities and Exchange Commission, along with state attorneys general in New York and Massachusetts, fined the Standard & Poor’s credit rating agency a total of $77 million for rating certain securities deals leniently, in a hidden effort to obtain new business. The SEC banned Standard & Poor’s from rating certain bonds for one year, and filed administrative proceedings against the executive, Barbara Duka, who orchestrated the fraud. S&P may also soon settle a similar case with the Justice Department and a dozen states for as much as $1.5 billion, which equals about a year’s worth of operating profit, over how they fraudulently rated mortgage-backed securities during the housing bubble.
From the headlines, you would think that the system worked here: Regulators found misconduct, put a stop to it, held the perpetrators responsible and made things safer. But you would be wrong.
The actions by Standard & Poor’s reveal a continuum both before and after the financial crisis, with the rating agency more concerned with attracting clients and turning profits than accurately analyzing investments. Whatever deterrence either the SEC or DoJ think will come from cash settlements is obviously contradicted by S&P carrying on business as usual. In fact, S&P will still get to rate most security instruments, even in areas where they were caught fixing ratings. The regulators could have put a stop to this by changing the business model that perpetuates ratings-shopping and profit-driven analysis, but they failed to follow through.
Let’s remember the history. The Justice Department’s lawsuit, which dates back to February 2013, accused Standard and Poor’s of misleading investors during the housing bubble. They blessed risky mortgage-backed securities with super-safe AAA ratings, despite knowing that the securities were junk. This lured investors into buying the securities, which all crashed in the crisis and caused massive losses.
Because the big banks who issue securities also pay for the ratings, S&P didn’t want to prevent future business from going to rivals by rating their offerings poorly. In one email revealed by the Justice Department, an S&P employee boasted, “We rate every deal. It could be structured by cows and we would rate it.” Documented reports by the Senate Permanent Subcommittee on Investigations and the Financial Crisis Inquiry Commission tell a similar story.
But the conduct the SEC fined Standard and Poor’s for last week occurred after the 2008 crisis. According to the SEC’s fact sheet, S&P misrepresented its methodology to investors in rating certain types of commercial mortgage-backed securities (CMBS) – backed by loans on office parks and malls – in 2011. They also published an article in mid-2012 touting its new CMBS ratings criteria, which included overhyped and flawed claims and amounted to a “sales pitch,” according to S&P’s original author of the study upon which it was based.
A third order in the SEC’s settlement concerned residential mortgage-backed securities (RMBS), the same types of investments that drove the crisis. S&P routinely does surveillance of previously rated products to see if the ratings should change. In their RMBS surveillance, they changed a critical assumption to make the analysis less rigorous, and failed to disclose this change to investors. The surveillance change occurred from October 2012 all the way to last June.
So Standard and Poor’s altered its ratings methods, mostly in pursuit of bigger market share and higher profits, years after it was initially caught. In fact, the New York Times confirmed this all back in July 2013, finding that S&P gave higher ratings than its competitors on MBS in an effort to win business. Incredibly, last week’s settlement represented the first enforcement action by the SEC against a major rating agency; it did absolutely nothing to punish rating agencies for the well-documented abuse that led to the financial crisis.
And the SEC’s penalty was not exactly as advertised, either. It played up the fact that it barred S&P from rating certain CMBS for one year. But the ban only covers multi-borrower, or “fusion,” CMBS, an area where S&P rates only 9 percent of all deals, according to Bloomberg. S&P can continue to rate single-borrower CMBS, and in that part of the business, they rate 82 percent of all deals. The “ban,” in other words, is akin to banning a fireman from making drug busts – they don’t do it anyway.
S&P uses the same looser methodology on single-borrower deals that it does on the multi-borrower deals for which it was fined – it just disclosed the change earlier to the SEC. While some observers find the single-borrower methodology unobjectionable, others, like former rating agency executive Marc Joffe, think it “should worry any observer of the rating agency business.” These deals are not diversified, Joffe writes, and the ratings simply do not reflect the potential for default at the commercial properties, citing previous AAA-rated CMBS dependent on individual loans that turned sour.
Meanwhile, this should completely change the situation at the Justice Department. Why would it settle with S&P on pre-crisis mortgage-backed securities claims if the company continues to exhibit the same behavior after the crisis? Shouldn’t this trigger a new assessment of S&P’s liabilities and the consequent punishment? After all, a large part of enforcing financial laws is the deterrent factor, to prevent such crimes from happening again. S&P already demonstrated by its actions that no such deterrent is occurring.
While the DoJ-led fine of $1.5 billion sounds big, it comes many years after the misconduct, and therefore represents a small portion of accumulated profits since that time. Plenty of businesses would break the law to make illicit profits in 2005 and 2006 if they didn’t have to pay a piece of them back until 2015. And only DoJ can send executives to prison for this behavior; the SEC does have an administrative proceeding against Barbara Duka for the CMBS fraud, but the most it can do is kick her out of the rating agency industry.
While the recent revelations of profit-driven analysis involve securities that aren’t big enough to topple the U.S. economy, the fact that S&P (and presumably its rivals too) continue to compromise the integrity of the system shows its fundamental failings, which could crop up and provoke crisis down the road if applied to a larger asset class. And the point is that the regulators had the opportunity to take care of all this, and missed.
During the Dodd-Frank debate, Sen. Al Franken wrote a provision that would have changed the compensation model for credit rating agencies. Instead of having rating agencies paid by issuers of securities – and subject to pressures to give AAA ratings to win more business – a governmental entity would randomly assign securities to each accredited rating agency, and the more accurate their ratings, the more business would be assigned. In other words, rating agencies would compete on quality rather than currying favor with the big banks.
But though Franken’s provision got 64 votes in the Senate, the Dodd-Frank conference committee watered it down, forcing a study of rating agency compensation practices that took several years. Though the SEC had authority to change those practices, they ultimately did nothing to implement the Franken model or really alter any part of the compensation system, opting instead for a few paperwork requirements. “Enforcement won’t be enough,” Franken said in a statement responding to the SEC’s action against S&P. “I'm frustrated that the SEC still hasn't moved forward with real reform to the credit rating industry.”
Until profit considerations get written out of the rating agencies, they will be unable to resist the temptation to loosen their evaluations and bless risky practices. That brought our economy to the brink of disaster once; nothing currently prevents such conduct from happening again.
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