SEC May Charge Ratings Agencies with Fraud

The Wall Street Journal reported this morning that the SEC is considering fraud charges against the ratings agencies that were responsible for evaluating the CDOs, or collection of loans, that ultimately led to the sub-prime mortgage crisis.  For those of you who may not be familiar with the issue, part of the strategy of selling the mortgages was to bundle a variety of loans into a single package (the CDO).  The bundles contained high-risk and low-risk loans, but because they were bundled up in a package, the ratings agencies gave the package a solid rating despite the high-risk loans bundled within.

According to the paper, lawyers point out that regulators commonly accuse financial firms of fraud if they intentionally or recklessly misrepresent information.  The WSJ reports that the ratings agencies under investigation could face allegations that they “relied on incomplete or out-of-date information supplied to them on the pools of loans in the mortgage-bond deals or ignored clear signs of problems” in the mortgage industry.  By doing so, they rated the products too high and misled investors as to their quality.

The Big Short: Inside the Doomsday Machine a fascinating book about the mortgage crisis by Michael Lewis, paints the ratings agencies as naive rubes who fell prey to the sophisticated selling tactics of the Wall Street trading firms.  In it, he points out that ratings agencies are paid to rate securities, and their customers (in this case, banks) want good ratings.  To us, the conflict of interest is obvious.  According to the Wall Street Journal (emphasis added):

To be sure, the credit-rating companies aren’t responsible for the accuracy of the data supplied to them to rate securities. But they could be accused of ignoring obvious flaws in the data, such as it failing to reflect the deterioration of the mortgage market, according to lawyers.

We’d add to that: or failing to conduct enough of their own research to establish independence from the organization submitting the security to be rated.

The continuing lesson for us at BYM: Wall Street deals are naturally stacked in favor of those who are closest to the market and the deals (and therefore know the most).  Much like the recent round of tech IPOs, it’s the traders who are going to make the most money.  Organizations like Moody’s are merely selling their opinion, which may be as uninformed as the man on the street.  In fact, when these agencies are dead wrong, they use the first amendment as defense.  The WSJ reports:

In May, the credit-rating firms notched a legal victory when a U.S. Court of Appeals ruled that they can’t be held liable for their ratings of mortgage-backed securities. Their ratings, the judges wrote, were “merely opinions” and protected by the First Amendment, a defense the firms have often used in the past.

And all of this is fine.  It’s just business, and we shouldn’t stop people from running businesses.  Our objection is when these businesses are treated like civic institutions, to be trusted implicitly, and rescued at taxpayer expense.  While Moody’s and Standard & Poor’s didn’t get bailout money, there were definitely part of the problem, and part of the system that we’ve propped up.

As always, let the buyer beware.

Raters Drawing SEC Scrutiny (premium content) | The Wall Street Journal

 

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