Standard and Poor’s downrated by charges

Institutions accused of financial misconduct typically resort to a couple of favourite excuses.

One is the "everyone else was doing it" defence familiar to parents of misbehaving children. London-based Barclays, among others, used this one to explain why it manipulated a key benchmark interest rate.

Another is the "unforeseen events overtook us" line. Richard Fuld, the former CEO of Lehman Bros., made this one famous by contending that his recklessly leveraged investment bank fell victim to "uncontrollable market forces."

Now it’s the turn of Standard & Poor’s, the credit rating agency that slapped AAA ratings on bundles of toxic mortgages in the run-up to the 2008 financial crisis. Charged with fraud by the Justice Department on Monday, S&P combined both the conformity and ignorance defences.

"S&P, like everyone else, did not predict the speed and severity of the coming crisis," said the company, which has a core mission of assessing and anticipating risk.

It’s all well and good that the Justice Department finally got around to charging S&P for putting sterling ratings on piles of junk. But, regardless of whether the government lawsuit succeeds, it does nothing to alter the fundamental conflict of interest afflicting the credit ratings industry and the investors who rely on its products.

The industry operated under, and still operates under, a flawed business model that crushes honesty and independent analysis. This model is called "issuer pays." It’s the equivalent of movie studios hiring their own film reviewers. The rating agencies get paid directly by the institutions selling the securities being rated, which puts pressure on the agencies to give high ratings or risk losing business to competitors. The system turns the agencies into marketing arms of the Wall Street banks instead of the independent watchdogs they are supposed to be.

Inflated ratings on toxic bundles of loans, many of them subprime and no-doc mortgages, were a key contributor to the housing bubble and subsequent economic bust. Had the credit agencies been in a position to give accurate ratings without seeing their revenue tank, they could have thwarted much of the mischief from Wall Street bankers, mortgage brokers and others.

But they didn’t. Not at S&P and not at other agencies. In one e-mail released by the Justice Department, an S&P analyst said "leadership was concerned of p*ssing off too many clients" if deals were downgraded "before this thing started blowing up." Another analyst’s e-mail in March 2007 included a parody of the Talking Heads song Burning Down the House: "Subprime is boi-ling o-ver. Bringing down the house."

Funny stuff.

Amazingly, the issuer-pays system is still in place. When the 2010 Dodd-Frank financial reform measure was being considered, the Senate adopted a bipartisan amendment that would have replaced the system with one where credit ratings would be randomly assigned by a newly created federal authority. The issuer would still underwrite the cost but would lose its ability to reward or punish agencies based on their ratings.

Regrettably, this was watered down in the final version of the law, which called for a study and gave the Securities and Exchange Commission the authority, but not a mandate, to implement such a system. So far, it has not.

Other models include having the buyers of debt products pay for the ratings. This is the most honest approach. Generally, if someone wants a complex issue researched, he or she has to pay for the research to get it done, or risks getting a biased product. This approach has enough opposition, however, that the randomly assigned ratings might be the best bet.

What won’t work is to leave the flawed system in place.