Two House Committee on Financial Services hearings Wednesday focused on overhauling financial products at a time when mortgage lenders and credit-rating agencies (CRAs) that assign ratings to securitized mortgages face criticism over their roles in the housing market collapse.
Lenders often face criticism for marketing and selling unsafe and unsound mortgage products to borrowers that did [...]

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Robert Waldmann

It would be easy to pass a law that issuers of securities aren’t allowed to pay ratings agencies. One problem is that if purchasers of securities paid for ratings, the ratings would have to be their secret at least for a while. One might add a provision that ratings be made public after x days for some x.

I don’t think this solves the incentive problem at all. Briefly, I think ratings agencies can decide if a class of financial instruments exists or not and, whoever pays them, have an incentive to make sure it exists by being generous to innovative financial products.

I do think an incentive scheme which would work is almost possible. I’d say no new regulations for old standard instruments like corporate bonds. For rating a not so traditional instrument ratings agencies can be paid only the salary of people who do nothing but rate that instrument plus 20% for overhead.

Now such rules haven’t worked very well for government contractors, but I think that’s the best that can be done.

Obviously this proposal is politically impossible. Aside from financiers and the ratings agencies disinterested observers who consider financial innovation to be socially useful will think it’s a terrible idea.

I respond “OK OK plus 30% for overhead.”

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California AG Jerry Brown joins the ranks of Attorneys General to scrutinize the disastrous role the credit rating agencies played in the financial crisis. On Thursday, Brown will announce the investigation’s launch.

From the press release:

San Francisco – At a news conference Thursday, September 17, 2009 at 10:30 a.m., Attorney General Edmund G. Brown Jr. will announce that he is launching an investigation into the role credit rating agencies played in fueling the financial crisis.

At the peak of the housing boom, these agencies gave their highest credit ratings to complicated financial instruments, including securities backed by subprime mortgages, making them appear as safe as government-issued Treasury bonds.

In rating these securities, these agencies worked behind the scenes with the same Wall Street firms that created them. For their work, the agencies earned billions of dollars in revenue, at a rate double what they earned for rating other financial products.

A good starting place could be this instant message exchange between two employees at S&P, one of the biggest rating agencies, captured in our Most Damning Internal Emails Of The Financial Crisis slideshow:

“Official #1: Btw (by the way) that deal is ridiculous.

Official #2: I know right…model def (definitely) 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.”

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Jonathan Bernstein submits:

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.

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Zero Hedge

Perhaps the Oracle of Omaha was right in starting to get out of Dodge with his MCO position, after he sold 8 million shares in mid-July, and noting that he very well may continue selling his remaining 40 million share stake. David Einhorn clarifies why.

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Zero Hedge

Of all organizations, the Richmond Fed was the last place one would expect a broad scope critique of rating agencies. Yet in a piece released today, this is precisely what the bank did, potentially paving the way for the next big whiplash as ever more politicians are already contemplating the next major scapegoat for when the market turns out to have been priced in just a little too much to perfection.

Alas, the problem with incentivisation, ratings shopping, and other less then virtuous approaches that the raters have been blamed for, have to start at the root of the problem, which, as is becoming prevalently clear, is Wall Street. The vicious triangle of Wall Street – Rating Agencies – SEC, has to be seen for the conflicted construct it is, and approached appropriately, if 3rd party “independent” raters can hope to salvage their business models, let alone their reputation.

An curious excerpt from the Richmond piece focuses on a topic near and dear to anyone who rebels against a tiered market:

Ratings are intended to be simply one tool of many for reducing asymmetric information, however. This logic was spelled out in the SEC’s initial regulations requiring institutions to rely on NRSROs. But the profitability and complexity of the securitization market in recent years induced investors to ignore this caution, a fact that issuers and rating agencies may have intentionally or unintentionally exploited.

It is precisely the concept of asymmetric information perpetuation that is the heart of Wall Street, as in its various forms, it allows those “connected” to, for lack of a better word, abuse those who are not. This asymmetry is prevalent and evident in every aspect of Wall Street (that has gotten public attention so far) – Flash, HFT, the “huddle”, ratings, preferred clients, selective bid/ask spreads, and many other topics that the mainstream media has not (or dares not) touch upon, but which Zero Hedge has every intention of disclosing for public consumption.

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Four stars, two thumbs up, a must read: Rave reviews like those might seem a bit suspect if they were paid for by the restaurateurs, movie makers and authors being reviewed.

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For the few sane people who have been watching and recoiling with horror as Bernanke, Geithner and Bair implement their insidious “rich get richer” PPIP/TALF plan by relying exclusively on the AAA ratings of the very same rating agencies that were the primary cause of the current economic catastrophe (yes Steve Liesman, not the CDS market or CDS traders – the rating agencies) today was a glorious day. In what could potentially become yet another voice for rationality and for the common people, Connecticut Attorney General Richard Blumenthal has joined his NY colleague in pursuing the crusade against the phenomenal conservative Wall Street-D.C. cronyism that is another key reason for today’s sad predicament.

In a letter released today by the CT AG, Bernanke has acquiesced that even he may be forced to change his dogmatic view, if put under sufficient pressure. Blumenthal, after months of pushing to prevent the big three rating agencies (Moody’s, S&P and Fitch) from being the main determinants on which assets are eligible for the Private-Public partnership programs, may have finally gotten his wish.

Some background: Blumenthal last month wrote Bernanke to complain about the TALF program (which Zero Hedge has discussed in excruciating detail in the past). The Fed mandated that for securities to be eligible for government support they must be rated by two or more “major” NRSROs (another name for the three horsemen of conflict of interest doom: S&P, Fitch and Moody’s). Paradoxically, neither Bernanke, nor Geithner, nor Bair, saw any problem with instituting the very same agencies that brought the credit system to the verge of total anihilation, as the same ones which should complete the destruction they attempted through the housing bubble. Luckily, Blumenthal has seen through this idiocy and has had enough.

I present Blumenthal’s full letter below as it is exactly the type of activism that public should expect out of its elected officials, who lately only care about channeling populist anger at all the wrong places (for the right places they should be looking in the mirror), and padding their bank accounts through special interest lobbies and budgetary inefficiencies.

Attorney General Writes To U.S. Treasury Secretary Geithner Calling On Fed To Stop Steering $400 Million To Credit Rating Agencies That Enabled Economic Meltdown

May 14, 2009

Attorney General Richard Blumenthal today released a letter calling on the U.S. Department of Treasury to intervene in a Federal Reserve bailout program that could unfairly steer up to $400 million to the Big Three credit rating agencies who enabled the economic meltdown by overrating risky securities.

In a recent letter to Treasury Secretary Timothy F. Geithner, Blumenthal urged that Geithner contact the Federal Reserve and request that it reverse its wrong-headed policy.

“It’s time to shatter the Old Boys Club of rating agencies,” Blumenthal said. “This senseless restriction rewards the same rating agencies who are at the center of our current financial crisis and whose shortcomings made these bailout programs necessary in the first place.“

Blumenthal contacted Geithner after Federal Reserve Chairman Ben S. Bernanke wrote to Blumenthal reiterating his refusal to stop giving the Big Three credit rating agencies — Moody’s Investors Service, Fitch Ratings and Standard & Poor’s – the exclusive right to rate securities eligible for the Federal Reserve’s $1 trillion Term Asset-Backed Securities Loan Facility (TALF), while cutting out smaller competitors who can also do the work.

TALF, which is intended to restart consumer lending, requires financial institutions to have new securities rated by two or more “major nationally recognized statistical rating agencies (NRSROs).”

Because the Federal Reserve Board deems that only Moody’s, Fitch and Standard & Poor’s are considered “major,” the requirement effectively shuts out their seven competitors who are approved by the U.S. Securities and Exchange Commission to do the work.

Blumenthal said these rules undermine recent federal legislation intended to encourage competition in the credit rating market by breaking the Big Three’s longstanding stranglehold on the market.

“The Federal Reserve’s policy is short sighted because it virtually guarantees a concentrated, non-competitive market in structured security credit ratings for the foreseeable future by shutting out other qualified rating agencies that stand ready to compete for TALF work,” Blumenthal said. “Overdependence on the Big Three credit raters is exactly what led to the current financial debacle.”

Bernanke, responding to an April 6 letter from Blumenthal, said the Federal Reserve limited ratings to the Big Three in order to protect the Treasury and the U.S. taxpayer.

Even in defending these rules Bernanke acknowledged to Blumenthal that, “the rating methods employed by major NRSROs for asset backed securities have exhibited significant shortcomings.“

Blumenthal said, “I strongly disagree that shutting out competition and relying only on rating agencies that helped create our economic meltdown protects the U.S. taxpayer.

“The Federal Reserve’s stated reason for favoring the Big Three that it has ‘customarily employed,’ perpetuates the Old Boy’s Club mentality that has been condoned for too long. The policy seems hardly likely to instill the sort of confidence in the due diligence undertaken by the Federal Reserve that U.S. taxpayers deserve and the markets merit.

“Just as the Federal Reserve must perform its own due diligence on this issue, the Treasury Department should require the Federal Reserve to publicly explain what due diligence was undertaken and why, as a result of this due diligence, only the three major credit rating agencies should be entrusted with rating the securities issued as part of the TALF. Otherwise taxpayers and investors remain unable to accurately assess the credit risk of asset-backed securities.

“If our financial system is going to continue to look to credit ratings for guidance in the world of structured finance, investors and the public in general need to have reason to believe that the credit rating agencies can accurately assess credit risk for these securities. The way to instill this belief is not by further entrenching the comfortable oligopoly of the past that generated such questionable work product.“

Zero Hedge salutes Mr. Blumenthal, and together with Mr. Cuomo, hopes that the two gentlemen run for office. Absent either of the two committing some Spitzeresque blunder, both have a clear road to the presidency, as long as they continue fighting what is so plainly and evidently a huge ploy by a select few to abuse the general population’s lack of understanding of the credit system, and in the process, as Richard says “entrench the comfortable oligopoly” of the rich. Zero Hedge will assist in this fight as much as it can.

In the meantime, in order to demonstrate to our readers just how much “less protected the U.S. taxpayer would be,” yet how much more correct and efficient the proper determination of risk would become if Bernanke actually were to allow a respectable rating agency such as Egan-Jones to conduct the relevant credit evaluations, I present the chart below, which demonstrates the credit ratings by Egan-Jones and Bernanke darling Standard & Poors, of a name that everyone is all too familiar with: General Motors. The chart really needs no commentary.

It is exactly this kind of “headless chicken” optimism that avoided dealing with the critical matter at hand until it was too late that has gotten us into this mess. It is the same “terminal optimism” that CNBC and other MSM conduits are spewing forth in order to generate an artificial feeling of calm with their counterfactual theories of green shoots, mustard seeds and other vivid and flawed floral analogies. It is no wonder, of course, that Bernanke and other members of the administration have every interest in perpetuating the optimistic fallacy as long as they can – why, just look at that U of Michigan consumer sentiment number: all is good – it only takes a massive short squeeze orchestrated by several select parties to get people to part with their hard earned money, to believe inflation is here, and to load up on their credit cards and take out a third mortgage, which would be fine and dandy with Obama, the Treasury and the Fed. And in the meantime, the unemployed among us multiply, the consumers’ purchasing power evaporates, malls are half full (and on their way to empty), formerly performing assets are barely generating cash, and the only houses sold are those in foreclosures or short sales. Enough with this insanity.

But i digress.

Any chance of fixing the system will have to come from an improvement within, first. As such Moody’s, S&P and Fitch must be, if not expelled, then certainly relegated to the periphery of agencies that make decisions about the creditworthiness of assets that will be ultimately purchased involuntarily by U.S. taxpayers under the guise of the TALF and the PPIP (for the benefit of PIMCO and Blackrock). Zero Hedge stands 100% behind Mr. Blumenthal’s effort and beckons our readers to do the same.

If there is to be any hope of fixing the system, which may already be terminally broken and so any efforts could, for practical purposes, be too late, it has to come from an honest desire to improve things, not to lever up the U.S. population for the second, and most certainly final, round of the great and suicidal credit bubble. ZH pleads with all powers that be in high up places to reconsider their ways before it is indeed too late. And if not, more people like the CT Attorney General will emerge, only to gradually regain control of a runaway system that is, at least for now, dead set on a certain course of destruction.

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April 3 (Bloomberg) — U.S. state insurance regulators may reduce their dependence on firms including Standard & Poor’s and Moody’s Investors Service, saying they are looking into ratings “shortcomings.”

The National Association of Insurance Commissioners has assigned a group to explore “the reasons for recent rating shortcomings” and “the problems inherent in reliance on ratings,” the group said in a statement on its Web site.

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