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Sep 30 2008

Why the Wall Street bail out plan is bad-6: The credit ratings agencies scandal

In voting down the bailout proposal 228-205 yesterday, the House of Representatives struck a small blow for democracy. They refused to be steamrolled by Wall Street and its agents in Congress and the administration.

As usual, in the run up to the vote, the administration met in secret with the Congressional leadership, worked out some vague plan, gave the House members just a few hours to see the bill, and then ordered the House members to vote for it or else, saying “Trust us, we know what is best. If you immediately don’t do what we say, the world will come to an end.”

Why exactly is this so urgent? Why cannot a solution wait for weeks or even months? This crisis was not created in a day, why must it be ‘solved’ in a day? On the rare occasions when the question is posed of why this urgency is necessary, the response is incoherent, vaguely referring to the need for ‘confidence’ and ‘calming the markets’.

This attempt by an elite to ram through a policy with major consequences without extended debate is an insult to the democratic process and is symptomatic of an oligarchic system, not a representative democracy.

There should be public hearings when such a major issue is involved. There should be open testimony from all relevant parties as to what exactly the problem is and the pros and cons of the various options. Everything should be out in the open and completely transparent.

To their credit, enough members resisted the president, Treasury Secretary, Fed Chair, and the leadership of both parties (such as that blustering bully Barney Frank) and said resoundingly “No!” Of course they will now come under intense pressure and blamed for losses on Wall Street. But the goal of the government should be the general welfare of people and the broader economy, not to protect stock prices in the short term.

The members of Congress who voted no should resist pressure and not capitulate until they get a deal that is genuinely in the interests of ordinary people and not Wall Street. The only way we are going to get any serious and meaningful reform of the deeply flawed financial system is in exchange for the bailout money. Once you give Paulson the ransom he is demanding, it’s all over. You can forget about getting any long-term solutions.

And now we return to the regularly scheduled post . . .

In my post on the current financial mess, I pointed out the key, and scandalous, role played by the credit ratings agencies like Moody’s and Standard and Poor which gave the highest ratings of AAA to these mortgage-based securities although they did not deserve them. This was important since major public funds (like pensions) that deal with the savings of many lower and middle-income people are required to only invest in the safest securities. So getting the AAA rating was essential if this vast pool of money was to be tapped.

An article in Bloomberg News reveals how the top executive at these ratings companies pressured their analysts to give these highest ratings without the normal scrutiny they should receive, because “Without those AAA ratings, the gold standard for debt, banks, insurance companies and pension funds wouldn’t have bought the products.”

Flawed AAA ratings on mortgage-backed securities that turned to junk now lie at the root of the world financial system’s biggest crisis since the Great Depression, according to Raiter and more than 50 former ratings professionals, investment bankers, academics and consultants.

“I view the ratings agencies as one of the key culprits,” says Joseph Stiglitz, 65, the Nobel laureate economist at Columbia University in New York. “They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.”

What these ratings agencies did was to take short cuts and depend on computer-driven mathematical models and their competitors’ analyses rather than do their own field research. In fact, people were not interested in even seeing the properties on which their ratings were based.

In late 2005, First Pacific’s Mann says, he invited East Coast investors to take a subprime mortgage tour up California’s main interstate artery, to see the problem for themselves. The I-5 runs from San Diego to Sacramento, passing through Orange County, Bakersfield and Stockton.

“Nobody wanted to do it,” he says. “Unfortunately, most of the models were constructed by people who hadn’t seen most of America and certainly weren’t familiar with the areas they were rating.”

The article describes how the analysts were pressured.

“We must produce a credit estimate,” Gugliada, a member of the structured-finance rating group’s executive committee, wrote to Raiter in a March 2001 e-mail. “It is your responsibility to provide those credit estimates, and your responsibility to devise a method for doing so. Please provide the credit estimates requested!” he wrote, signing off with his nickname “Guido.”

“He was asking me to just guess, put anything down,” says Raiter, interviewed at his home in rural Virginia, 69 miles (111 kilometers) west of Washington. “I’m surprised that somebody didn’t say, ‘Richard, don’t ever put this crap in writing.’”

Gugliada, like Raiter, now says that he views as flawed many of the ratings S&P and Moody’s assigned.

“There was the self-delusion, which hit not just rating agencies but everybody, in the fact that the mortgage market had never, ever, had any problems, and nobody thought it ever would,” Gugliada says.

But then came the reckoning.

Driven by competition for fees and market share, the New York-based companies stamped out top ratings on debt pools that included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes between 2002 and 2007. As subprime borrowers defaulted, the companies have downgraded more than three-quarters of the structured investment pools known as collateralized debt obligations issued in the last two years and rated AAA.
. . .
Bank writedowns and losses on the investments totaling $523.3 billion led to the collapse or disappearance of Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. and compelled the Bush administration to propose buying $700 billion of bad debt from distressed financial institutions.

At bottom, the problem was the incestuous relationship between the companies seeking the ratings and the ratings agencies that bestowed them.

Through it all, the rating companies had a basic conflict: They were paid by the businesses whose products they rated. Moody’s told the Paris-based Committee of European Securities Regulators in November 2007 — in the 49th footnote of a 35-page response to its questionnaire on structured-finance — that it allowed managers who supervised analysts to “provide expert input” on fees “in a limited range of circumstances.”

SEC Chief Cox said in June that the rating companies engaged in the “lucrative business of consulting with issuers on exactly how to go about getting” top ratings.

This what happens when you take away oversight and mindlessly extol the virtues of the ‘free market’ and blandly assume that ‘the market will correct itself.’ Greed runs rampant.

POST SCRIPT: McCain and the Keating Five scandal

Given the strong similarity of the current Wall Street bailout scandal to the earlier savings and loan scandal of the 1980s, you would have thought that the media would have paid more attention to that story, especially since John McCain was one of the five US senators fingered as being influenced by the notorious Charles Keating, who went to jail for his role. Keating was a benefactor of McCain and a close friend of Cindy McCain.

For those not familiar with that earlier episode here is the story of McCain and Keating told in less than two minutes.

5 comments

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  1. 1
    Greg

    Hi Mano,

    Excellent interview with a David Cay Johnston on the bailout.

    http://www.salon.com/opinion/greenwald/radio/2008/10/01/johnston/index.html

  2. 2
    Austin Clark

    Mano,
    I agree the bailout package is really a bad idea. I am an attorney and small business owner and not a great economist. But common sense would tell you that the bailout is not going to work. First, buying “bad” debt is like giving an aspirin to a man who is shot in the head, for an headache. What they need to be concerned about is the cause of the bad debt.
    Austin Clark

  3. 3
    Really Bad Credit Offers

    Great article Mano. You are right on target, and your words have proved fruitful, as even now its being revealed that much of the bailout money is being set aside for acquisitions rather than the suggested increase of credit capital for the little guys.. oh well.

  4. 4
    Good Credit

    D.C. Johnston is the best. Interesting to see now that sentiment is getting even more negative to the bailout and yet they are pushing through the second round! Buying bad debt isn’t the answer, and I for one think we are just fanning the flames. Great post, thanks!

  5. 5
    Scott Lovingood

    As a small business owner and libertarian, I found the whole debacle of how the government has handled this “financial crisis” to be appalling.

    The bailout plans helped those in power and those with wealth. It did little to nothing for those who make the actual economy go.

    I have found that just about anytime Congress rushes to pass anything, it leads to many unintended consequences.

    History has definitely shown that to be true for this series of attempts by the government. Centralized government has never worked. The preponderance of evidence has shown that decentralized methods have a much stronger impact on the economy.

    Unfortunately time has also proven that no matter who gets elected, they tend to think they can still solve the issues by passing more laws.

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