Department of Justice Sues Standard & Poor's
Years after the worst financial crisis since the great depression in 1933, perpetrators and those thought to be held responsible for this catastrophe are still being brought to justice. The U.S Department of Justice along with Senator Carl Levin, who heads the Senate's Permanent Subcommittee on Investigations, maintain that:
"S&P lied about its ratings being free of conflicts of interest because it downplayed or disregarded credit risks to win more business from investment banks and other issuers of the securities that paid the company to provide the ratings and that sought the highest possible ratings."
If these accusations are proven true, they will carry grave penalties for Standard and Poor's. Currently the Justice Department estimates that S&P can face $5 billion or more in civil penalties "based on losses by federally insured financial institutions that relied on S&P's ratings" (Bloomberg).
So, what really went wrong.. We know that S&P provided false and inflated ratings on structured financial products, but what does that all mean? When it boils down, S&P are being accused of giving such "financial products," like Collateralized Debt Obligations (CDO's) and Residential Mortgage-Backed Securities (RMBS), inflated or a false ratings. S&P's obligation is to rate the CDO's and RMBS's in an unbiased and objective manner, with no incentive to rate investments other than for their real value. Here lies the moral dilemma. S&P was essentially hired by the investment banks that were selling the CDO's and RMBS's. If Standard and Poor's credit ratings on something that the investment banks are selling (CDO) is high , or AAA for that matter, business is good for everyone. S&P looks good, and the investment banks sell their CDO's, and RMBS's because of S&P's high ratings. Because Standard and Poor's credit ratings are suppose to be objective and truthful, selling these bundles of debts should not carry a ? over them. If the ratings are good, than there is no reason to not want to buy a AAA credit rated investment.
Because S&P issued false credit ratings, CDO's and RMBS's that were sold from investment banks misguided third party buyers to believe the credit ratings were good. Buying these bundles would normally represent a safe investment with a low risk, but not in this case.
From the Glass-Stegall Act of the 30's, to the Dodd-Frank act of 2009, we have seen Congress try to regulate the financial district of Wall Street for the protection of citizens and their investments. Although a central question remains, does regulation of investments and banks actually have an effect on how the industry operates? Or will the lucrative aspect of making a fortune on Wall Street by doing the wrong thing prevail?
I would argue that while regulation should be implemented to protect consumers and investors, regulation does tend to restrict commerce. In the light of the 2008 financial crisis and the role that rating agencies played in it, I would say that more regulation is absolutely necessary. Regardless, I would also argue that more rules give companies more opportunities to find loopholes in those rules; greed prevails.
ReplyDeleteI think credit rating agencies are good because chances are someone with bad credit should not be racking up more credit.... and that's where the agency comes into play. As far as providing false ratings... I have not heard much about this, but I cannot imagine it being a common issue to worry about. but maybe it is? Overall I think it's a security thing and security is good...
ReplyDeleteThe main issue is that there was no institutional framework in place for credit rating agencies to compete without facing perverse incentives to mispresent financial products. Without any regulations, the credit rating firms faced a race to the bottom scenario in the context of free competition. By rating a financial product riskier, the firm would potentially lose clients to other credit rating firms. Thus Standard & Poor's had very little choice but to misrepresent risk in order to stay competitive.
ReplyDeleteI agree with Ian on this issue, the lack of institutional framework breeds reckless behavior like this. Institutions and regulations are necessary to at least keep things functional and in check. I think this is a significant case for the Dept. of Justice because credit rating agencies in the past have been able to defend against civil lawsuits basing their claims that the information they received was derived from independent opinions. Now, the court ruling has found that this is not an issue not of opinions, but rather and issue of misrepresentation of information. Thus, this case will elevate from realm of shoddy practices into the realm of fraud.
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ReplyDeleteI think it's important to note that although credit agencies played a large role in the financial crisis, it is also true that investors accepted these inaccurate ratings without investigating their true value and validity . These ratings were only estimates and the investors did not accurately assess the entirety of all associated risks themselves. Furthermore, the data and information provided by credit agencies only takes into consideration a handful of investment variables and their ratings are no substitute for investment risk management.
ReplyDeleteI think there are limits to what regulation can accomplish as well. According to the New York Times, pressure to convince regulators that they are standing on firmer ground has actually driven many banks, like Citigroup, into making hushed back ally deals, particularly in Europe. The article, Seeking Relief, Banks Shift Risk to Murkier Corners, says that banks, rather than sell assets at a loss can "transfer a slice of the risk" to other institutions in a manuever known as "capital relief trades" or "regulatory capital trades". The buyers, such as private equity firms, typically hedge funds, whose investors are often pensions. These trades push risk into a less “regulated corner”, so it can look less alarming on the books, which relaxes the amount of capital regulators expect banks to hold in reserves.
ReplyDeleteI definitely think there is a need for more regulation, like the Dodd-Frank Act, but I think a fully comprehensive regulation policy might be an unattainable notion. Like Ben said earlier, more rules give companies more opportunities to find loopholes. In the end, you can't put regulation on greed.