About The Role of the Ratings Agencies In the Financial Crisis

I’ve mentioned a number of times, most recently here, that I think that if you don’t want to blame the buyers of crappy financial products for making crappy capital allocation decisions, then the Blame Game path inevitably leads to the ratings agencies.  Well, today, shares of Moody’s ($MCO – no positions) and McGraw-Hill ($MHP – no positions – MHP owns Standard and Poor’s) got decimated (albeit, in seemingly slow motion: it took a little while for the selloff to pick up steam…) on news that MHP expects an investigation from the Department of Justice regarding their role in the crisis.


As the AP article notes:

“The U.S. government is expected to file civil charges against Standard & Poor’s Ratings Services, alleging that it fraudulently gave high ratings to mortgage debt that later plunged in value and helped fuel the 2008 financial crisis.

The charges would mark the first enforcement action the government has taken against a major rating agency involving the financial crisis.

S&P said Monday that the Justice Department had informed it that it intends to file a civil lawsuit focusing on S&P’s ratings of mortgage debt in 2007. The action does not involve any criminal allegations.

S&P denies any wrongdoing and says any lawsuit would be without merit.”

MHP actually filed an 8-k, explaining a little more about why they think the lawsuit would be without merit, and it’s well worth excerpting here:

“A DOJ lawsuit would be entirely without factual or legal merit. It would disregard the central facts that S&P reviewed the same subprime mortgage data as the rest of the market – including U.S. Government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained – and that every CDO that DOJ has cited to us also independently received the same rating from another rating agency.  S&P deeply regrets that our CDO ratings failed to fully anticipate the rapidly deteriorating conditions in the U.S. mortgage market during that tumultuous time. However, we did take extensive rating actions in 2007 – ahead of other ratings agencies – on the residential mortgage-backed securities (“RMBS”) which were included in these CDOs. As a result of these actions, more collateral or other protection was required to support AAA ratings on CDOs.  With 20/20 hindsight, these strong actions proved insufficient – but they demonstrate that the DOJ would be wrong in contending that S&P ratings were motivated by commercial considerations and not issued in good faith.”

So, this is actually pretty interesting (and there’s much more in the filing).  First, of all, I find it interesting that MHP is using the “even the US Government (I think they really mean the Fed) didn’t see this shitstorm coming” excuse.     That’s not a crazy excuse (although I’m not saying it’s a good one!): the “smarter people than us fucked this up too” excuse – the Fed probably has a lot more information than Standard and Poors does, and we all know about Bernanke’s infamous “problems in subprime markets seem likely to be contained” error.   Furthermore, MHP is also going with the “our peers also demonstrated the same level of gross incompetence we did” excuse – only that’s probably not what they’d call it:  they’d call it the “our peers saw things in the same light we did, so we can’t be guilty of fraud here.”

I very much agree with MHP that we cannot prosecute based on hindsight, which gets back to the question:   if these products were so obviously craptastic, whose job was it to see that?

I have written thousands of words on this blog explaining my answer to that question:  I believe the buyers of the paper are responsible for evaluating the efficacy of the productwhen you commit capital, it’s your job to do the research.  We all know, however, that much of this “research” was rubber stamped by the fact that the ratings agencies (that’s MHP and MCO) had “done the research” themselves and come up with the vaunted “all clear” AAA rating on so much doody.

There is a lot of confusion because “civilians” seem to be missing the point that the banks constructing these fantastic piles of crappy layers of crap-squared don’t have a fiduciary duty: their job is to give buyers and sellers what they want.  The buyers wanted AAA paper, which they got*.    What happened is that the sellers did all of the work, and the buyers relied on the fact that they assumed that Moody’s and S&P had done the work when they came to their AAA conclusions.   Did the banks who created this stuff exploit the ignorance of the ratings agencies?  Absolutely*.

So anyway, since it still seems that we as a society are reluctant to blame the ignorantly allocated capital on the buy-side of all of this crap, the next logical “enabler” is the ratings agencies, who, in my opinion, were grossly negligent.   Does the fact that the Federal Reserve was also grossly ignorant of the risks abdicate the ratings agencies?  I don’t think so.   But if one wants to argue that it was far from obvious what was going to happen, one also cannot come down on the “these big banks were such evil manipulators who constructed products that they knew would blow up” side – that’s kinda what my babbling here is trying to say.

Let me sum up:   Capital was committed by managers who were negligent in their research.    I think that the reason that these managers were negligent in their research is because they blindly trusted the ratings assigned by Standard and Poor’s and Moody’s, and thus didn’t do the due diligence they should have done.   Does that mean that they have a right to sue the ratings agencies?  Oy vey – it’s time for a heavy dose of I AM NOT A LAWYER.   I’m pretty sure the ratings agencies don’t make any guarantees about their evaluations of products…

I guess in the Utopian market-driven-world, The Market realizes that the ratings agencies didn’t know JACK, and starts to seriously discount their “opinions.”   However, greed is often a stronger catalyst than fear, and I don’t expect we’ll start seeing the ratings of financial products ignored any time soon: it’s easier to listen to  Moody’s and S&P than do actually do your own real work – and therein lies the problem.

update: the full complaint

edit: read Matt Levine on the subject too

related:  David Merkel: In Defense of Ratings Agencies

MHP 8-k

The Best Paragraph I’ve Read in a Long Time



* My narrative here has basically been of the storyline:  The ratings agencies, like the buyers of these financial products, were lazy and ignorant.   In other words, I am assuming that their “crime” was gross ignorance, and not “fraud.”   There is, of course, the possibility that the banks and ratings agencies fraudulently coordinated efforts to boost ratings and thus deceive investors for profit, which would be illegal.    However, I need to put my I AM NOT A LAWYER hat on again, and ask why such violations would be the subject of a CIVIL suit (which this is), and not a criminal one… I don’t know the answer – perhaps it’s this:

“During settlement negotiations, the Justice Department held out the threat of a criminal case against S.&P., the people briefed on the matter said. Ultimately, the government plans to bring a civil suit, which has a lower burden of proof than a criminal case.”


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