In another strike of the blinding obvious, the SEC has finally determinedthat the large credit rating agencies responsible for assigning credit ratings for the bundled subprime loans, had conflicts of interest in determining those ratings.
Pause
One, two, three, four, five, six, seven, eight, nine, ten.
Deep breath.
Back in March I gave you information about what the typical subprime loan and “bond” (actually bundled loans) looked like. It wasn’t a pretty description! I stated at the time:
On the one hand I’m mad. Over 75% of the subprime loans reviewed in this study received the highest bond rating of AAA. How stupid is that when you look at the make up of the borrowers. With real interest rates nearly 5% above the norm, it was clear that there was significant risk in this package. I hate the government involved in business but someone needs to step in and change the way that bond rating agencies do their rating.
Beyond the “irrational exuberance” of ever increasing real estate prices, a big piece of shame for the subprime debacle needs to go to the rating agencies.
The rating that the agency gives the various debt instruments has a large impact on the market’s appetite for that debt. Under “normal” market circumstances, if the agency were to give a rating that was lower than expected, the market would expect higher risk and respond by demanding a higher interest rate thereby increasing the overall costs for the issuer. The impact would be that mortgage providers would have charged higher interest rates to the borrowers and that would have allowed fewer of the mortgages and less of the debt to come on the market. If the rating came back with an unexpectedly low rating (which it should have in at least some of these loans), it could have prevented the issuer from finding a buyer at all and that would have cut short future issuance of subprime loans.
The reason why “normal” market forces didn’t work properly is due to the conflict of interest that the SEC “found” but has really existed for years. Rating agencies get compensated for providing their rating on a particular debt or bond issuance. The payment comes from the entity trying to sell or place the bond. If the rating agency gives a poor rating causing either higher interest costs or an inability to sell debt, they get no future business. If they make the debt easy to sell in the market, the rating agencies could expect to see additional business from the folks trying to sell the debt.
2005, 2006 and early 2007 were very heady days for the stock prices of the large agencies. Note any patterns?
So the agencies were getting paid by their customers, so what? Isn’t that how the market works? The answer is yes except when the incentive is so great that it skews your ability to provide an allegedly unbiased answer.
You may remember the name of a little accounting firm called Arthur Andersen. They used to do the audit for another company you may remember, Enron. At the time it was not unusual for large accounting firms to perform financial audits at a loss. They did this because they also typically had a relationship with the client to perform various consulting services. The consulting services were always higher margin and were what many accounting firms made much of their revenue from…in the day. After Enron’s collapse the SEC figured out that if you made a whole lot of money off of consulting services and virtually no money off of an audit, your client had the ability to hold the consulting services over your head to ensure an acceptable opinion on thier audit….even if they were doing things that weren’t exactly kosher…at least that’s what I’ve heard.
When an entity that holds itself out as independent, like CPA firm or a rating agency, has financial entanglement, it has the potential to destroy that entities independence. My opinion is that the rating agencies were completely focused on generating revenues and never thought that providing an “encouraging rating” would ever matter to anyone. They were wrong and we’re all being impacted by their unintended consequences.
