August 7, 2020

High & Low Finance: How S.&P. Tempted Arthur Andersen’s Fate

They were the gatekeepers, with a clear conflict of interest — the people they were supposed to check up on were also the ones who hired and paid them. The need to protect their reputation was supposed to assure that the conflict would not lead to bad behavior.

But it did not. Those within the firm who wanted to be tough found themselves outmaneuvered by those who wanted to make compromises to keep business that might otherwise be lost to competitors — competitors who were not above making compromises themselves. It was not that they wanted to act badly, only that they did not want to offend important customers. They had no idea that the corners they were cutting would blow up into a scandal that would dominate the news, shock the nation and lead to the demise of the firm.

That is a description of what happened to Arthur Andersen, the accounting firm, more than a decade ago.

It may turn out to be a description of what will happen to Standard Poor’s, the ratings agency, as a result of its behavior during the housing boom.

The good news for S. P. is that it faces only civil liability from the suit filed this week by the Justice Department. It was the criminal complaint against Andersen that sealed the firm’s fate.

But the allegations in the suit are reminiscent of what happened at Andersen, whose image had previously been of being the most independent, and most committed to quality accounting, of the major firms.

Until now, the role of the credit ratings agencies in the financial crisis had seemed — to me, at least — to be defensible. They may have been foolish or even stupid, but they were not venal. They applied their models in good faith in rating mortgage-backed securities. Their models proved to be overly optimistic, but the housing collapse was an unprecedented event. Being wrong is not a crime.

The Justice Department suit offers a different sequence of events. As the housing bubble grew, and the revenue from rating the deals skyrocketed, S. P. was determined to stay competitive with other agencies — Moody’s and Fitch — in getting the business. That led to tinkering with models and ignoring inconvenient evidence so as to produce the ratings that were desired by the banks putting together the deals. Even when it became clear that new deals did not deserve the ratings they were getting, S. P. chose to issue high ratings.

By not filing criminal charges, the government got a lower burden of proof — preponderance of the evidence rather than beyond a reasonable doubt — while the potential for a $5 billion fine provides punishment as severe as any criminal case against a corporation could.

It is important to understand the financial alchemy that was involved in rating mortgage securitizations.

In the corporate world, to get a top rating a company has to have a sterling balance sheet and good prospects. But not in the world of securitizations. The logic was that a lot of clearly risky subprime mortgages could be put together and — presto, become mostly AAA in a residential mortgage-backed security, or R.M.B.S. Since it was extremely unlikely that more than, say, 20 percent of the mortgages would default, 80 percent of the money that financed them could be raised by issuing AAA-rated securities.

And the agencies took that one step further. Put together junior securities from a bunch of such deals and issue a new securitization, called a collateralized debt obligation, or C.D.O., and most of it was AAA too.

The result was that the boom in subprime lending was financed by investors who were told they had supersafe securities. The bubble would not have happened without S. P. and its peers.

The Justice Department has evidently been through every memo, e-mail and text message sent out by S. P. analysts and executives from 2004 through 2007, and found some that sound as if bosses were putting the short-term commercial interests of S. P. — both the fees it got and the need to maintain good will with the investment bankers who chose which rating firm to use — ahead of truth.

The most recent events the government complains about happened in 2007, and there are five-year statutes of limitations in some fraud laws. So the government turned to a 1989 law that makes it illegal to defraud a bank — a law passed during the savings and loan scandals — that has a 10-year statute of limitation, and cites case after case where banks bought the securities S. P. rated, and lost money. Some of those cases sound real, but as Jonathan Weil of Bloomberg News has pointed out, in some cases the bank that S. P. is supposed to have defrauded is the very same bank that put together the securitization, and kept part of it. It seems like a stretch.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2013/02/08/business/sp-may-have-tempted-arthur-andersens-fate.html?partner=rss&emc=rss

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