Rating For Fun And Profit

Via Ezra Klein, James Surowiecki has a story about the nation's credit ratings agencies - Moody's, S&P, Fitch - who gave toxic waste sterling ratings that encouraged investors to buy them, leading to a collapse of the financial system. You can add to this the fact that the ratings agencies are funded by the banks, who have a compelling interest in having their crap be given triple-A ratings. But Surowiecki argues that government needs to take some of the blame for this as well.

[O]ver the years the government has made the agencies an increasingly important part of the financial system. Rating agencies have been around for a century, and their ratings have been used by regulators since the thirties. But in the seventies the S.E.C. dubbed the three biggest agencies — S. & P., Moody’s, and Fitch — Nationally Recognized Statistical Rating Organizations, effectively making them official arbiters of financial soundness. The decision had a certain logic: it was supposed to make it easier for investors to know that the money in their pension or money-market funds was going into safe and secure investments. But the new regulations also turned the agencies from opinion-givers into indispensable gatekeepers. If you want to sell a corporate bond, or package a bunch of mortgages together into a security, you pretty much need a rating from one of the agencies. And though the agencies are private companies, their opinions can effectively have the force of law. The ratings often dictate what institutions like banks, insurance companies, and money-market funds can and can’t do: money-market funds can’t have more than five per cent of their assets in low-rated commercial paper, there are limits on the percentage of non-investment-grade assets that banks can own, and so on.

The conventional explanation of what’s wrong with the rating agencies focusses on the fact that most of them are paid by the very people whose financial products they rate. That problem needs to be fixed, and last week the S.E.C. proposed new rules to address conflicts of interest. But there’s a much bigger problem, which is that, even though nearly everyone knows that the agencies are compromised and exert too much influence, the system makes it impossible not to rely on them.

Predictably, despite the ratings agencies' central role in the financial crash, nothing has changed with them, because the government has stamped them with authority and investors need their numbers to carry out deals, pretty much by law.

If government created this monster, they need to play a role in reversing it. In New York, inspectors with the state Insurance Department are considering dropping Moody's from its list of approved ratings agencies. The National Association of Insurance Commissioners (who collectively oversee an industry with $3 trillion in rated bonds) has proposed the same for the entire Big Three. And Jerry Brown has issued a subpoena to the Big Three agencies to investigate the ratings they gave to subprime mortgages. But ultimately, while this may keep the ratings agencies in line, you need to eliminate the official imprimatur from government and force the ratings agencies to compete on their own credibility. Further, the regulatory requirements actually force investors to sell downgraded securities quickly, leading to panic selling based on ratings that don't have a lot of backing behind them. That needs to be tweaked as well.

Surowiecki explains why this won't happen:

Oddly, the ratings system, broken as it is, remains attractive to many investors who have been burned by it. For one thing, it provides an easily comprehensible standard: without it, we’d need to come up with new ways of measuring risk. More insidiously, the ratings system provides a ready-made excuse for failure: as long as you’re buying AAA-rated assets, you can say you’re being responsible. After the housing crash, though, we know how illusory those AAA ratings can be. It’s time for investors to face reality: working with a fake safety net is more dangerous than working without any net at all.

I think, given the safety net under the bottoms of the major banks, that they'll take that fake one from the ratings agencies and live with it, thank you.

A Year After Lehman

A year ago, Lehman Brothers collapsed, sparking a financial meltdown that nearly took the global economy with it. The problem, as many saw it, concerned giant banks taking huge risks and putting greed ahead of responsibility. The solution, one year out, has been to stuff those giant banks with money to prop them up, while making them bigger and allowing them to take exactly the same risks.

One year after the collapse of Lehman Brothers, the surprise is not how much has changed in the financial industry, but how little.

Backstopped by huge federal guarantees, the biggest banks have restructured only around the edges. Employment in the industry has fallen just 8 percent since last September. Only a handful of big hedge funds have closed. Pay is already returning to precrash levels, topped by the 30,000 employees of Goldman Sachs, who are on track to earn an average of $700,000 this year. Nor are major pay cuts likely, according to a report last week from J.P. Morgan Securities. Executives at most big banks have kept their jobs. Financial stocks have soared since their winter lows.

The Obama administration has proposed regulatory changes, but even their backers say they face a difficult road in Congress. For now, banks still sell and trade unregulated derivatives, despite their role in last fall’s chaos. Radical changes like pay caps or restrictions on bank size face overwhelming resistance. Even minor changes, like requiring banks to disclose more about the derivatives they own, are far from certain.

Coming on the same weekend as the 11th-hour bailout of the giant insurer American International Group, and the sale of Merrill Lynch, Lehman’s failure was the climax of a cataclysmic weekend in the financial industry. In the days that followed, nearly everyone seemed to agree that Wall Street was due for fundamental change. Its “heads I win, tails I’m bailed out” model could not continue. Its eight-figure paydays would end.

In fact, though, regulators and lawmakers have spent most of the last year trying to save the financial industry, rather than transform it. In the short run, their efforts have succeeded. Citigroup and other wounded banks have avoided bankruptcy, and the economy has sidestepped a depression. But the same investors and economists who predicted, and in some cases profited from, the collapse last fall say the rescue has come at an extraordinary cost. They warn that if the industry’s systemic risks are not addressed, they could cause an even bigger crisis — in years, not decades. Next time, they say, the credit of the United States government may be at risk.

First Alan Greenspan, and then Ben Bernanke, have offered the biggest forces in the financial industry a "put" - a price at which they will bail out investors for any risky asset they manage to buy. Asset prices have been artificially inflated by the threat of collapse and the overriding principle of "too big to fail". In fact, Lehman is seen by many in the halls of power as an EXAMPLE of too big to fail - as their collapse triggered a crisis, the decree was made that such a collapse can never happen again.

And so we have the big firms growing even bigger. And the level of risk they take on basically the same, although leverage is a little bit reduced (maybe 15:1 instead of 25:1). And the regulatory structure is largely unchanged. The same regulators are accumulating even more power despite having missed all the signs of collapse a year ago.

Here’s a novel thought. Instead of creating more regulations to try to prevent this kind of mess from recurring, why not figure out how to hold regulators accountable when they perform as poorly as they did in recent years?

Edward J. Kane, a professor of finance at Boston College and an authority on the ethical and operational aspects of regulatory failure, has some ideas about how to do this and right our damaged system in the process. He outlined them in a recent paper titled “Unmet Duties in Managing Financial Safety Nets.”

This ugly financial episode we’ve all had to live through makes clear, Mr. Kane says, that taxpayers must protect themselves against two things: the corrupting influence of bureaucratic self-interest among regulators and the political clout wielded by the large institutions they are supposed to police. Finally, he argues, taxpayers must demand that the government publicize the costs of efforts taken to save the financial system from itself.

What we have now is the same self-interested power brokers holding control over the financial industry, and a federal government which has plugged its fingers in the dike, from which they are reluctant to let go lest disaster strike again. The industry has been weaned on these tremendous public investments and become used to them. The exit could be painful and I'm not convinced that the overall industry even welcomes it. They've got a pretty good thing going - the profits get privatized, the risk gets socialized.

To the extent there is a recovery, the President deserves a little credit. Yet he is rapidly squandering the opportunity to truly recast the financial industry into their traditional role, as facilitators of the flow of capital but not hoarders of it. The crisis point was a natural time to make the necessary changes to the system, not after that feeling of crisis has lifted and the Masters of The Universe are playing with house money again. Politically, it gives the sense that the bailouts were simply a handout to industry instead of an exchange of help in the near term for wide-ranging fixes in the long term. The President took to Wall Street today to argue for financial regulatory reform, but it's going to be difficult to get this through while the banks have all the leverage. He's going to say that normalcy cannot lead to complacency. He's going to say that the rules must be tightened to ensure that we never again subsidize the casino that has become Wall Street. That includes a Consumer Financial Protection Agency to protect those who buy mortgages and take out credit cards. It includes reining in derivatives and leverage. It includes accountability for the credit ratings agencies who got their job completely wrong because their incentives were allied with the same interests who sold the crap. It includes the ability to wind down banks that are too big to fail, making them too big to exist.

I'm pessimistic that all of this will actually happen, though. A year after Lehman, it feels like the time for reform has passed. And that's extremely dangerous for the nation.

Charles Schwab Makes The Mistake Of Telling The Truth

Maybe it's because their headquarters are on Montgomery Street in San Francisco instead of Wall Street in New York, but Charles Schwab Co. is telling investors that California is not about to go out of business.

In a rhetorical question-and-answer missive to investors, Schwab income planning director Rob Williams, says "California has severe financial problems, but we think it's unlikely that the state will default on its general obligation (GO) bonds."

Then he lists five reasons for reaching that conclusion, including constitutional guarantees; the fact the state can't file for bankruptcy, and the fact that "states can't just disappear."

So does the firm see the state's current travails as "a buying opportunity?" "No one can say for certain," says Williams.

Here's the document. As Williams says, general obligation bonds are guaranteed by the state constitution, and only education is ahead of paying off these bonds. Here's a sample:

Many analysts point out that the state’s revenues are collapsing, its spending is out of control, and the structure of government prevents the state from ever being fiscally stable. Are these concerns valid?

All of these statements may be true, depending on your political view. But these troubles don’t inevitably translate into default on California GO bonds, for all of the reasons cited above.

However, they do translate into serious concerns for other parties interested in the state’s solvency—of which there are many. The politics of the situation can also be noisy, leading to steady reporting of the budget drama and ebbs and flows in market sentiment, likely adding to uncertainty and reducing confidence among investors. As confidence drops, the prices of outstanding bonds drop, and yields rise.

The situation has also resulted in changes to the state’s bond rating, including a downgrade by Fitch Ratings to BBB on July 6 and Moody’s to Baa1 on July 15. These ratings are two and three notches, respectively, from "junk" bond status. The rating is also on negative "Rating Watch," meaning that the rating will remain on review for additional downgrades "if institutional gridlock" persists.

While ratings alone should not drive an individual investment decision, comments in Fitch’s rating report are worth quoting: "The BBB rating indicates that expectations of default risk remain low, although the rating is well below that of most other tax-supported issuers. GO debt in California has a constitutional prior claim on revenues, although after education."

In other words, diving into Fitch's rating report, they essentially admit that their rating is bullshit. They are dropping the ratings because of perceptions of crisis that don't match constitutional obligations. This is gouging. It's almost the textbook definition of it.

And if you don't think that goes on, check out this investigative report from last November:

Goldman, Sachs & Co. urged some of its big clients to place investment bets against California bonds this year despite having collected millions of dollars in fees to help the state sell some of those same bonds.

The giant investment firm did not inform the office of California Treasurer Bill Lockyer that it was proposing a way for investment clients to profit from California's deepening financial misery. In Sacramento, officials said they were concerned that Goldman's strategy could raise the interest rate the state would have to pay to borrow money, thus harming taxpayers.

"It could exaggerate people's worries about our credit," said Paul Rosenstiel, head of the public finance division of the treasurer's office.

That's exactly what's happening. The big banks are sparking irrational worry over California's ability to repay bonds to increase their yields. The federal government needs to step in with a backstop, not just to save the state money, but to prevent the commission of a crime.

CalPERS Goes After The Rating Agencies

People are justifiably worried that credit ratings agencies like Moody's, Fitch and S&P have lowered California's credit ratings to near-junk bond status. The nature of the way we pay our bills means that we will eventually have to access bond markets to borrow, and these low ratings will dramatically increase the cost of that borrowing. I've said often that the risk of default on any bond issue, as a Constitutional matter, is infinitesimal, yet in this case, the rating agencies are being overly conservative and reflecting the fears of Wall Street.

And yet the rating agencies are not independent actors. They are owned by banks who issue the securities they rate, and throughout the financial meltdown, they continued - almost until the end - to rate mortgage-backed securities filled with subprime loans at the highest quality, facilitating the buying frenzy. In fact, the rating agencies structured many of the deals in order to ensure high ratings, intervening in the market for those securities instead of dispassionately assessing them. Now CalPERS, the largest public pension fund in the country, which has been hammered by losses in the stock market, is suing those rating agencies for their gross negligence.

The lawsuit blames the three big Wall Street credit rating agencies – Moody's Investors Service, Standard & Poor's and Fitch Ratings – for effectively luring CalPERS into a series of disastrous 2006 deals by giving the investments "wildly inaccurate and unreasonably high" grades.

The investments have gone bust at a cost of "perhaps more than $1 billion," said the California Public Employees' Retirement System in the suit, filed last Thursday in San Francisco Superior Court.

The losses represent a small portion of the roughly $60 billion CalPERS has lost in the past year due to declines in its stocks, real estate and other holdings. The losses are so steep that CalPERS has served notice that it will demand higher contributions from the state and the local governments that rely on the fund for pensions.

As a large industry actor, CalPERS has some ability to move policy in the financial world. And they are hitting one of the biggest targets here. Barry Ritholtz explains further:

Now, here comes the fun part: Calpers doesn’t give a rat’s ass about the money. Sure, the financial instruments at hand (Cheyne Finance, Stanfield Victoria Funding and Sigma Finance) have defaulted on their payment obligations. The losses to Calpers are ~!$1 billion.

But that’s not what’s going on here: These Left Coasters want their pound of flesh. They don’t care for the Ratings Agency folks, and consider them a blight on the investment landscape.

The goal of the litigation (as I see it) isn’t to make the rating agencies pay a financial penalty; rather, it is to publicly try them just as the regulatory rules are being rewritten. I also predict that CALPERS is going to attempt to not just win, but humiliate these agencies, call them out in the most embarrassing way possible, trash the senior executives, and make things very uncomfortable in general for these firms.

They don’t want them to merely suffer — they want to destroy their unique position as an Oligopoly, to remove them from having a special status under the SEC rules.

The credit rating agencies are a FRAUD, and I would argue that this downgrading of California bonds regardless of Constitutional dictates represents a furthering of that fraud. CalPERS is fighting back on principle, because the relationship between the rating agencies and the financial industry they are supposed to serve is among the sleaziest on Wall Street.

Under Phil Angelides, CalPERS used its considerable clout to move toward progressive reforms in the financial industry. Bill Lockyer has done less of this. But I'm glad to see the fund standing up on behalf of not only its clients, but every investor, against the near-criminal structure of these rating agencies.

Triple-B

Fitch, one of the main credit rating agencies, fresh off downgrading California bonds from A to A-minus a little over a week ago, just took them another step down today.

The downgrade to 'BBB' is based on the state's continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis. Since no agreement was reached by the June 30, 2009 fiscal year (FY) end, the state's controller has now begun issuing registered warrants (IOUs) for certain non-priority payments to preserve cash, and the budget gap to be addressed has increased to $26.3 billion from $24.3 billion. The use of IOUs for non-priority payments would offset cash shortfalls into September 2009 as now currently projected [...]

With issuance of IOUs for non-priority payments, margins for meeting constitutional and court-required contractual commitments are narrowing. After September 2009, absent any proposed budget and payment adjustments, cash deficits will expand dramatically. Cash flow solutions, including the ability to access short-term borrowing, are inextricably tied to reaching timely agreement on effective and credible budget solutions.

The inability of the state to reach agreement has prompted the controller to begin issuing IOUs for non-priority payments, primarily disbursements to vendors, for certain social services, and for tax refunds, in order to ensure payment of priority payments, including General Obligation and lease debt service. The controller's office estimates that $3 billion in IOUs will be issued during July 2009; priority payments of $10.8 billion will be made for education, debt service, Medicaid, payroll, pensions and other mandatory contractual obligations. Projections will be revised to reflect June revenue performance and other changes but as currently estimated, cumulative cash deficits of $3.7 billion are projected through August, offset by $4.5 billion in non-priority payments that could be covered with IOUS, excluding tax refunds. However, by the end of October, the projected cash deficit expands to $16.1 billion, well beyond non-priority spending of only $10.6 billion, excluding tax refunds.

It's true that the IOUs work only until October. But the credit rating is specifically tied to, in this case, long-term bonds. And as I've laid out previously, as a matter of law debt service has pride of place in the state Constitution - only education must be funded before it. It would take something like $50 billion dollars in program cuts before creditors must be paid, which is far less than current debt obligations.

In other words, this is a gouging effort by Wall Street, and the credit ratings agencies are downgrading California simply because they can. The fact that every single creditor will get paid in full if California has to close every hospital and prison in order to do it is of little consequence. This is all further reason why the federal government ought to provide loan guarantees to stop the gouging from Wall Street.

Not So Green Shoots

I acknowledge that there are signs that the economy is on an upswing. But the optimistic scenarios don't jibe with all the data. First of all, the deficit keeps rising due to continued unemployment. That's to be expected, but it will still make it harder for any second stimulus to occur, meaning that we're pretty much stuck with the policies currently in place. The lower tax revenues has led to the first April deficit in 26 years, as typically April is a big enough revenue month that money coming in outweighs money going out. And the deficits are affecting the US credit rating, the ability to obtain cheap money.

Now, I don't want to dwell on the budget deficit, especially because in the near term it can't matter as much as getting people back to work. But it constrains the politically possible in Washington, and it will prevent the Administration from delivering additional help to the economy, which clearly it desperately needs:

Foreclosures in April exceeded even March's blistering pace with a record 342,000 homes receiving notices of default, auction notices or undergoing bank repossessions, according to a regular industry report.

One of every 374 U.S. homes received a filing during the month, the highest monthly rate that RealtyTrac, an online marketer of foreclosed properties, has recorded in four-plus years of record keeping.

"April was a shocker," said Rick Sharga, a spokesman for RealtyTrac. "I would have bet on a dip because March foreclosures were so high.

Instead, filings inched up 1% from March and rose 32% compared with April 2008.

Thanks, opponents to cramdown!

Now, interestingly enough some banks have been so chilled by threats of prosecution in the states that they have started to settle out of court in predatory lending cases, with much of that money going toward reducing principal for homeowners. If that practice becomes more widespread, perhaps we can stop this second wave of foreclosures.

One hears a lot about loan modifications these days. So far there are two basic approaches.

I) The borrower is given relief in the form of a lower interest rates and stretched-out maturities. The homeowner stays in the home.

II) The bank will accept a deed in lieu of the mortgage. The homeowner is out of the home.

There have been very few cases where a homeowner is allowed to stay in the home and achieve a principal reduction. The Boston settlement opens the floodgate for principal reduction. It is the essence of the agreement. All 714 borrowers are now eligible for principal reduction and the money is just sitting there waiting to be collected.

One can imagine the conversations between neighbors in Boston:

A: “Good news finally! I just got 35% net off my first and second mortgage.”

B: “Wow! How did you manage that?”

A: “I was lucky enough to get my mortgages through Goldman Sachs. They did a deal with the Mass AG and I win the lotto!

B: “I have my mortgages with Indy Mac Bank can I get reduction too?

A: Sure. Here is the number to call. Now lets party!

I really want the Administration to succeed, but I hope they aren't being swayed by all this happy talk. We're still in a dangerous place.