The Los Angeles Times reports an unusual move by Standard & Poor’s (S&P) into highly partisan politics by asserting that California’s fiscal problems stem from the tax code. This, says S&P, is the “core problem.”
The agency sidestepped the key Republican argument that California’s dire financial straits are the result of uncontrolled spending. Instead the LA Times quotes S&P as saying, “We don’t see the state’s existing spending level as the key source of its budget distress,” S&P’s report said. “In fact, the state is currently spending less as a share of its economy than it has at any point in the past 39 years.”
The report also went on to explain that they believe tax revenues have grown too slowly and have become increasingly unreliable due to the state’s over-reliance on taxing the very wealthy. Whereas the richest 1% provided 2.7% of the state’s general revenue funds in 1972, in 2010 it was up to 11%.
U.S. District Judge Shira Scheindlin has ruled to allow suits filed by King County, Washington, and Iowa Student Loan Liquidity Corp to proceed. They had invested in two vehicles, named Rhinebridge and Cheyne, that they complained the rating agencies, Fitch, Standard & Poor’s, and Moody’s collaborated in structuring and then gave a falsely high rating.
The investors had sued the defendants for negligence, negligent misrepresentation, breach of fiduciary duty, and aiding and abetting. Scheindlin allowed the plaintiffs to proceed with the negligent misrepresentation claims and dismissed the other three complaints.
In her opinion supporting her decision regarding Rhinebridge she wrote, “Plaintiffs have sufficiently alleged that the rating agencies possessed unique or specialized expertise, and that the rating agencies knew and intended that their ratings would be used by investors in deciding whether or not to invest in Rhinebridge.”
Scheindlin continued citing the investors’ complaint. “Regardless of their historical roles, the rating agencies did not merely provide ratings; rather, they were deeply entrenched in the creation and operation of Rhinebridge.”
This is a bad decision. What happened to the investors’ burden of due diligence? How can there be a breach of an opinion? Isn’t anyone responsible for their own decisions?
Writing for CBS Money Watch, columnist Constantine von Hoffman wonders, “Why are ratings agencies still in business?”
He cites two examples. The first is Standard & Poor’s upgrade of Greece’s sovereign debt “from really, really, really bad to merely very, very bad.” He doesn’t believe that Greece deserves a better rating, particularly in light of the then pending Greek elections.
He writes, “On Saturday, Greece will hold national elections in which anyone favoring budget cuts will be lucky not to finish at the bottom of the Aegean Sea.” He also points that markets reacted to the upgrade by driving the yield on Greek Bonds up even higher.
The second example is how the recent downgrade of Spain’s sovereign debt was “shrugged” off by the markets. He explains, “investors have known for some time that the economy there is a train wreck.”
He concludes by pointing out, “the agencies didn’t just miss the boat on mortgage securities, they missed the whole ocean.”
In a press release, Public Sector Credit Solutions and PF2 Securities Evaluations announced that they have released an open source framework for analyzing and rating government bonds.
The tool estimates the risk of default by assessing the likelihood of sovereign, state, and municipal bond issuers exceeding a user-specified fiscal threshold in any given year. This probability is then converted into a rating.
PF2 Consultant Marc Joffe explains that the tool’s objectivity is its greatest benefit. “Rating agency sovereign and muni bond groups do not take advantage of the power and objectivity of quantitative techniques, leaving their methodologies vulnerable to bias and inconsistency,”
The tool’s open source platform is also an advantage. Anthony Randazzo, Director of Economic Research at The Reason Foundation, commented, “An open source tool like PSCF is a great answer to complaints about rating agency transparency. By linking a government’s projected debt burden to its risk, the framework sends the right signal both to bondholders and policymakers.”
The parent company of Standard & Poor’s (S&P), McGraw-Hill Cos., announced that Deven Sharma, president of S&P, will be replaced by Douglas Peterson. Mr. Peterson is currently the Chief Operating Officer of Citibank N.A. Prior to that position, Mr. Peterson was CEO of Citigroup Japan.
While with Citigroup, Mr. Peterson established a reputation as a leader who is able to handle government scrutiny, improve business standards, and repair damaged reputations.
Mr. Sharma will be staying with the company as an advisor until the end of the year. The reason given for the change is that Mr. Sharma, who joined the company in 2006, is “ready for new challenges.”
During his tenure, Mr. Sharma separated S&P’s data, pricing and analytics business from its rating business. No mention was made in the announcement about how S&P downgraded the U.S. debt under Mr. Sharma’s watch, a move that was stridently criticized by the administration and was not followed by the other two major ratings agencies. Nor was there any mention of the ongoing Justice Department’s investigation into whether S&P improperly rated mortgage-backed securities while Mr. Sharma was president.
investments by the rating agencies and sold by some of the country’s largest banks, the U.S. government is intending to sue. The Federal Housing Finance Agency (FHFA) that oversees Fannie Mae and Freddie Mac, is hoping to be compensated for billions in losses.
The claim is that the banks misrepresented the quality of the securities. The FHFA issued 64 subpoenas last year to see the underlying documents for the mortgage-backed securities in which Fannie and Freddie had invested. The purpose given for the subpoena was to ascertain whether banks and other financial entities were liable for losses suffered by Fannie and Freddie, losses covered for by the U.S. Treasury.
Maybe we can also ask the buyers and managers of Fannie and Freddie what due diligence they did at time of purchase.
Larry Elkin, President of Palisades Hudson Financial Group, LLC, wrote on the company’s web site that the Security and Exchange Commission (SEC) is abusing its investigative power. He believes two SEC inquiries into Standard & Poor’s (S&P) to be retaliation for lowering the rating on U.S. debt. These SEC investigations deal with whether S&P had improperly rated mortgage-backed securities and if there was insider trading over the U.S. downgrade.
Mr. Elkin agrees that the SEC’s mortgage-backed securities investigation predates the downgrade; nonetheless he questions whether these actions by the SEC had, “…nothing to do with the actual decision by S&P to cut Treasury’s rating. Administration officials and its SEC appointees would never dream of retaliating against a rating company for honestly expressing its constitutionally protected opinions. We know this because, though they will not say anything for attribution, they say so in all the stories reporting on their inquiries.”
Mr. Elkin says the SEC’s refusal to say anything for attribution is “baloney” and urges all the rating agencies to, “…withdraw its rating of U.S. government and agency debt. They should explain that government investigations render them unable to express an independent opinion. As a result, the government will end its tenure as a AAA-rated credit risk, not by having its ratings reduced (except for S&P), but by having them eliminated.”
The Federal Housing Finance Agency (FHFA) has filed 10 causes of action against Goldman Sachs; of these, the more serious are for fraud. The agency is hoping to collect $11.1 billion plus interest for the lost securities and legal fees.
Courtney Comstock of Business Insider quotes a key passage from the lawsuit: “Because the information that Goldman provided or caused to be provided [to ratings agencies] was false, the rating were inflated…[and] also that Goldman Sachs knew, or was reckless in not knowing, that it was falsely representing the underlying process and riskiness of the mortgage loans…because Goldman’s longstanding relationships with the problematic originators, and its numerous roles in the securitization chain, made it uniquely positioned to know the originators had abandoned their underwriting guidelines…[and because] as a result, the GSEs paid Defendants inflated prices for purported AAA (or its equivalent) Certificates, unaware that those Certificates actually carried a severe risk of loss and inadequate credit enhancement.”
Because Goldman Sachs was not the originator of the mortgage loans, where the actual fraud took place, Ms. Comstock believes that Goldman Sachs has a strong defense. However the suit claims that Goldman Sachs was updated daily on the number of defaults but chose to securitize these failed loans anyway. Ms. Comstock also believes that Fannie and Freddie Mac were “sophisticated investors” who should have done their due diligence. To this the FHFA claims that the substandard loans were hidden; there is no way they could have known.
Good plan. Use the laws and rules that exist. If there is fraud, prosecute!
Fitch Ratings President Paul Taylor addressed the feasibility of a three-day warning period before changing a country’s sovereign debt ratings. Among other issues, Mr. Taylor worried about insider trading. He told a panel of British lawmakers from Britain’s upper chamber of parliament, “One of the leakiest areas in our business is sovereign ratings…if you inform the Greeks of a rating decision you get phoned up by the French. Countries tend to talk to each other.”
Taylor also claimed that the ratings agencies’ power is overstated. Instead the lawmakers should focus on the business press. Reuters reports Taylor saying, “It’s overstated, the power we have in markets. A lot of that comes from the press. The financial press in particular loves the idea we wave our wand and magic things happen.”
Currently countries are given 12 hours to challenge any factual errors, however the Europeans are exploring the possibility of expanding that to three days. The politicians are looking for a longer grace period to avoid wild swings in bond prices while bailout packages are being negotiated.
This is pure folly. You can never regulate volatility.
The Securities and Exchange Commission’s Rule 17g-5 was intended to introduce greater transparency and discourage credit ratings shopping. In practice it has made raters and issuers nervous to speak openly.
The rule requires that credit rating agencies share confidential loan-level arranger-provided information with other rating agencies on a password-protected website. Likewise, any verbal conversations, including phone calls and texts, must be recorded and documented on the website.
Rui Pereira, head of U.S. residential mortgage-backed securities at Fitch is quoted by Reuters as saying, “People are so concerned about litigation and risks that the operational review and ratings process has become a lot more complicated…Any questions about a deal must be e-mailed, and sent ahead of time.”
Another senior analyst from a different rating agency told Reuters , “Communication is ridiculous…I call an issuer with a question and he says, ‘I can’t answer that. E-mail that question to me and I’ll get back to you.’ It was so easy in the past. You just get on the phone to discuss it. With 17g-5, you eventually get the information you want, but it takes the longest way to get there.”
Although the rule’s purpose was to promote an equitable flow of information and motivate unsolicited ratings, it hasn’t worked. Since the rule went into effect, no rating agencies have issued an unsolicited rating.