You might think Standard & Poor’s has something against the U.S. government, the way the ratings firm treated the nation's credit rating on Friday.
In fact, it does.
It's hard to view the monumental ratings downgrade in context without understanding the long-running feud between the government and ratings agencies. In April, Sen. Carl Levin, D-Mich., issued a scathing 650-page report contending that malfeasance at ratings bureaus like Standard & Poor’s was as much to blame for the housing bubble as any bank, and included a series of smoking gun e-mails that suggested that the firms knew they were profiting from unethical behavior. A little-known section of the Dodd-Frank financial reform bill also hits the rating agencies with new limits destined to undercut their lucrative business; the Securities and Exchange Commission is discussing right now just how to implement the new rules. The public comment period on new rules ended Monday.
Is the timing a coincidence? Or could the ratings downgrade from Standard & Poor’s be viewed as a shot back at a government that's been taking plenty of shots at the ratings industry lately?
To be sure, no one needs Standard & Poor’s to say the U.S. government's coffers are in sorry shape. But this feud over the lucrative and arcane business of granting credit ratings shouldn’t be ignored.
For years, federal agencies and Congress have made attempts to reform the credit ratings business, which on its face is a bit absurd -- part accountancy, part cheerleader, part judge and jury of the financial system. As things stand, firms that want to borrow money from the bond market seek out a seal of approval from companies like S&P, Moody's and Fitch, and pay handsomely for it. The firms say they isolate fee collection from ratings judgment, but the business model is the very definition of a conflict of interest -- and the firms' actions during the height of the housing bubble call into question their ability to keep the ratings business free of profit-driven influence.
"It's like one of the parties in court paying the judge's salary," Levin said recently.
This crazy system hasn’t always been in place. People who really needed accurate ratings – investors – once paid ratings agencies for them, a so-called subscriber model. The 1929 market crash showed the ratings weren’t worth the paper they were printed on, however, and ratings agencies went searching for a different model. By the 1970s, they’d settled on a more stable business model, called “issuer-pays.” The market might go up and down, as does the quality of the ratings advice, but there is an endless stream of firms who want to borrow money and want new bonds rated.
The challenges of such a model are obvious, however, and were laid bare by the housing bubble.
Levin's report includes testimony from an endless stream of former employees who say they felt pressure to grant top ratings to new bond issues, lest they lose deals to competitors. In fact, the housing bubble was very, very good for the ratings agencies -- Standard & Poor’s fees from mortgage-related bond issues quadrupled from $64 million to $265 million between 2002 and 2006, the report found.
Internal e-mails from the various firms show that warning bells were repeatedly ignored. A 2006 email from an S&P employee cited in the report said the rating agencies "have all developed a kind of Stockholm syndrome," held captive by banks. Another e-mail cites an employee openly fretting about the agencies facing their "Nixon moment," when the housing bubble finally burst.
The problem hardly began with the overheated housing market, however.
"The absence of timely downgrades in these cases was a product of an industry that was beset by conflicts of interest and a lack of competition. Ultimately, this compromised the integrity of the market and investors paid the price," a prominent U.S. senator stated nearly a last decade ago. That senator was prominent Republican Richard Shelby of Alabama, now one of the most skeptical voices in Congress about the current round of financial reform. Shelby uttered those words after ratings agencies were cited as one of the causes of the Enron debacle in 2001 -- and as Republican President George Bush signed into law the Credit Rating Agency Reform Act in 2006. It was designed to prevent another Enron -- or at least to prevent ratings agencies from causing one.
At the time, lawmakers blamed the virtual duopoly that Moody's and S&P held on the ratings market, and the law made it easier for competitors to join the industry.
That didn't work. Instead, newcomers simply accelerated the "race to the bottom," and made a nefarious strategy called "ratings shopping" even easier. If a bank wanted to issue a mortgage-backed security, it could shop it to various agencies and pick whichever firm offered the highest rating. The temptation for competitive forces to overwhelm good accounting was enormous.
When the day of reckoning came for the housing bubble, the ratings agencies pulled the Band-Aid off the wound with one quick, brutal yank. In July 2007, S&P downgraded 1,100 mortgage related securities, an unprecedented volume. The massive downgrades were immediately preceded by equally massive new issues, however. In the first week of the same month, S&P issued 1,500 new positive residential mortgage-backed securities ratings, and Moody's did much the same, raising the obvious possibility that the right hand didn't know what the left hand was doing -- or worse.
"(It) raises serious questions about whether S&P and Moody’s quickly pushed these ratings through to avoid losing revenues before the mass downgrades began," the Levin report said.
In response to the report back in April, S&P rejected the assertion that the ratings agency helped cause the bubble burst.
"We regret that, like many others, we did not foresee the speed and extent of the housing downturn, which was the steepest decline since the Great Depression," spokeswoman Catherine Mathis told Bloomberg at the time.
S&P spokesman David Wargin flat-out denied to msnbc.com that the current regulation process had anything to do with the firm's assessment of the U.S. government's debt-worthy-ness.
"There's absolutely no connection between Dodd Frank regulation and any analytical decision we have made," he said.
It might be hard to win over critics who say the ratings agencies have a history of allowing outside factors to influence ratings decisions, however.
The Dodd-Frank financial reform bill includes a series of measures that once again attempt to curtail the conflict of interest that is pervasive in the ratings world, which would almost certainly cut severely into the easy money the ratings agencies enjoy. For the first time, the SEC can actually decertify a ratings agency for allowing profit motives to influence ratings, a fatal stroke that would cut it off from participating in government-related investments. It also strips the agencies of their long-treasured legal immunity from making mistakes: Before Dodd-Frank, it was essentially impossible for investors to sue over blatant ratings errors, like that ones that were common during the housing bubble. Now, ratings firms can be found liable if an investor proves they were reckless or knew the ratings were inaccurate.
But regulating the credit agencies has proven to be a near-impossible task. Not only are they intertwined in almost every corner of the market, they are intertwined with government agencies, too. Most state pension funds, for example, require that their managers only invest in funds with high ratings, which acts as a de facto endorsement of the agencies' work.
And the agencies have such a strong role in the markets that they can bully regulators into backing off.
In July 2010, with the increased liability provision of Dodd-Frank set to kick in, ratings agencies scored a victory by telling bond issuers they could no longer include the ratings on marketing materials. Because SEC rules require credit ratings to appear, the ratings agencies effectively created a Catch-22, threatening to shut down the entire asset-backed bond market. Regulators, faced with that potential calamity, backed off, and said issuers could temporarily issue bonds without the ratings. In December, the SEC made the change permanent, "effectively exempting companies from part of the U.S. Dodd-Frank Financial Rreform Act," according to a Bloomberg News report at the time.
So did S&P issue a downgrade to send a "back off" message to the U.S. government?
There's no evidence of it, and even ratings agency critic Barbara Roper said she was skeptical of such a quid-pro-quo conspiracy.
“They have used bullying tactics in other areas … but I don’t see how they’ve strengthened their hand by angering the very administration officials who are making those (regulatory) decisions about them,” said Roper, director of investor protection for the Consumer Federation of America. “They have no friends in Congress.”
On the other hand, it's undeniable that there's a macro-level conflict of interest at work when the very industry Congress is trying to reform unleashes its biggest arrow right at the heart of the financial system.
“It's clearly a problem that (the ratings agencies) have this much influence on the markets, including the power to undermine faith in the government trying to regulate them,” she said.
And whatever the motivation this time, Standard & Poor’s has clearly demonstrated its ability to move markets – and maintains more bullets in its chamber. Another downgrade, which the agency said was possible, would take U.S. debt out of the critical “top 2” tiers of ratings, which would prevent a host of pension funds and money market mutual funds from holding U.S. Treasuries.
“It’s not like they don’t still have a gun to the administration’s head,” Roper said. “They could be saying, ‘How’d you like that? Want to see it again?’ “