Liveblogging The Rating Agencies Hearing

Buffett just offered a standard defense of Corporate America that allows companies to do terrible things without any accountability.

Buffett is the largest shareholder in Moody's. He says over and over again that he believes in due diligence-- making sure you understand what you invest in. But Douglas Holtz-Eakin and Phil Angelides pressed Buffett on whether he knew or should have known Moody's was doing terribly reckless things that endangered the global economy.

Buffutt responded that he didn't know, and he couldn't be expected to know. Companies are complicated, and no shareholder can understand everything that a company is up to.

This is an astonishing statement in a couple of respects. First, rating securities is the business Moody's is in, and they screwed up just about every aspect of that business they could have, from corporate debt to synthetic CDOs. This was not one employee somewhere misunderstanding one deal-- this was the entire company missing every aspect of its business.

But here's the bigger question: shareholders are owners. If the largest shareholder doesn't know what a company is up to, and can't be expected to, how can you possibly expect that corporation to ever act in a responsible way?

Complexity has become a dirty word in finance. Financial transactions have become so complicated that people simply cannot effectively evaluate them. That same problem is reflected on a larger scale in the way financial institutions operate. Nobody can effectively manage a behemoth like Citigroup that engages in hundreds of different multi-billion-dollar businesses-- that's why the company collapsed.

Berkshire Hathaway is not as bloated as Citi, but they've got their fingers in a lot of different businesses, from pharmaceuticals to laundry detergent to derivatives to banking. Buffett is here acknowledging that even a super-businessman like himself cannot be expected to understand key points about his business because it is simply too complex.

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More dissembling from Buffett on derivatives. Peter Wallison asked him why Buffett does such a huge business in credit default swaps, while blasting them in public as "financial weapons of mass destruction."

"I think I actually said derivatives," Buffet responded. Wallison then asked Buffed what he uses derivatives for.

"I use them to make money. If I think they're mispriced, I buy 'em."

But Buffett soon acknowledged that, like AIG, the main derivatives business of Buffett's own firm is to sell credit default swaps (CDS). In some cases, CDS are a form of insurance, which is what Buffett says his company does. In other cases, CDS are pure speculative gambles, in which the sellers "lay off the risk" by selling their contract to a third party.

"I never lay it off," Buffett said. "We sell insurance."

"This is much like what AIG did, isn't it?" Wallison asked.

Buffett laughed the comment off, but that is in fact what AIG did. And AIG went under because it did not appropriately price the credit insurance it was selling on mortgage-backed securities. AIG was essentially selling insurance on subprime mortgages, but it didn't collect anywhere near enough in insurance premiums to cover themselves in the case of having to make a claims payout on a subprime mortgage default. Instead, AIG executives converted those insurance premiums to bonuses and made millions for themselves while setting the company and its shareholders up for a catastrophe.

If credit default swaps remain unregulated, and if companies like Berkshire Hathaway do not have to put up capital and margin against their derivatives trades-- or conduct those trades on an open exchange-- they can easily go the way of AIG. Buffett has a strong record as a shrewd investor and risk manager, but he will not be in charge of Berkshire Hathaway forever, and we do not want the entire derivatives market to depend on a few derivatives superheroes never making mistakes. On the contrary, we know that the market is a hotbed for fraud and abuse because it takes place off exchanges. To "rip the face off" an investor is Wall Street slang for a derivatives deal done well.

Nevertheless, Buffett lobbied against exactly those things-- exchange-trading and posting capital and margin on derivatives trades. He was not acting in the long-term interest of society there, he was protecting his earnings for the next quarter, just like the executives of big banks. Buffett is still a self-interested corporate titan, despite his folksy midwesternism.

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One really important new revelation has come to light during the first panel of today's Financial Crisis Inquiry Commission hearing on rating agencies. People at the rating agencies did not realize that securities and derivatives were being created for the explicit purpose of failing. They slapped top ratings on many of these deals, without realizing that there were people involved in the transaction who wanted it to torpedo.

Although Moody's officials didn't mention Goldman by name, this situation has a very significant bearing on the SEC's current fraud suit against Goldman Sachs-- and on our understanding of how the housing bubble inflated to such a catastrophic magnitude. Goldman created a very complex security called a synthetic CDO, in order to allow a hedge fund kingpin to bet against it. Goldman itself also bet against the security, while selling the same security to others as a safe investment.

The SEC's case against Goldman is very strong, but the only reason it isn't an outright slam dunk is because Goldman maintains it was acting as a "market maker," rather than an "underwriter." When a bank underwrites securities, it is essentially creating those securities and packaging them for sale in the market as a sound investment. To bet against that security, or intentionally structure the security to lose money would be outright fraud.

But market-making is different. It's the sort of thing a Las Vegas bookie does. In market-making, the bank tries to find different investors who want to bet for and against something—say, the housing market—and then serve as the means for making that bet. This is what Goldman says happened with the synthetic CDO at the heart of the SEC's case. Goldman claims that it wasn't signing off on the quality of a new security as an underwriter, it was just facilitating a bet for two different types of investors who had opposing views of a certain asset. One thought subprime mortgages were a good investment, another thought they were a bad investment, and Goldman says that its deal was just designed to allow that bet to take place, not to imply that either bet would be good.

Now, there are plenty of reasons to believe that Goldman's defense is a total pack of lies, and that they were in fact acting as an underwriter. Blogger Steve Randy Waldman has the definitive account of this, and it's right [1]:

What happened here is nothing like what a market maker does. A market maker takes the other side of client-initiated trades, and then lays off the risk. ABACUS was initiated and sold by Goldman Sachs, at a hidden party's request. Goldman was unwilling to make a market for Paulson at a price he would have accepted, so it manufactured an entity willing to do so. Investors in that entity were not informed that they were dealing with an active, involved adversary. And Goldman has the nerve to call both sides of the arrangement 'customers.'

But today's testimony from raters at Moody's indicates that the very people who were assigned to rate these deals simply did not understand them. Moody's was rating complex derivatives and securities deals without realizing that they had been designed by people who would profit from their failure. This is not just testimony from interested parties trying to cover their tails—the key witness on this matter was Eric Kolchinsky, a Moody's whistleblower who is not well-loved by the rating agency's management.

This reinforces the narrative that rating agencies frequently acted as accomplices for bankers trying to pull over a major fraud on the broader economy. In this case, it indicates that rating agencies did not even realize the extent to which they were acting as accomplices—the banks had designed deals so complicated, the rating agencies couldn't even figure out what was going on. They went away and rated the deals anyway, and made a lot of money on it.

It's hard to feel sorry for the rating agencies. They screwed up, both through corruption and incompetence, and yet still made money. But that fact does not excuse the wrongs committed by bigwig bankers during the crisis. In this particular case, it shows that bankers were deliberately manipulating the rating agencies in order to mislead their own clients. That's terrible in and of itself. But creating these bogus subprime securities and derivatives fueled demand for subprime mortgages, which ended up wreaking havoc on neighborhoods all over the country. That's even worse.

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Buffett is already defending Moody's with statements that appear to be reasonable, but are in fact completely incoherent. Here's what he says about the top brass at bailed out banks:

"When society has to step in to save institutions . . . the CEO should go away broke."

So far, so good. But what about the CEO of Moody's and other rating agencies who fueled the bubble, sabotaged investors, but were clever enough to design a business model that was insulated from the housing fallout? For the CEOs of rating agencies, Buffett suddenly has sympathy:

"The entire American public eventually was caught up in a belief that housing prices could not fall dramatically . . . I believed it . . . that's the nature of bubbles, they become mass delusions . . . . They made a mistake that virtually everybody in the country made."

In short, Buffett wants us to come down on the top bankers, but not the CEOs of a rating agencies. And it just so happens that Buffett is the largest shareholder in Moody's, one of the top rating agencies.

This is a total contradiction. Why have sympathy for the poor rating agency execs but not the bank execs, if everybody is operating under the same delusion? Sure, the government didn't bailout rating agencies, but the bank bailouts were fueled in part by actions committed by rating agencies, who slapped top ratings on garbage subprime mortgage securities that banks bought. If rating agencies contributed significantly to the need for vast, socially destructive bailouts-- and there is no question that they did-- their executives should be held accountable for that social fallout.

Buffett's argument seems to be that, since Moody's managed to profit from its own social sabotage, it should be immune from public or regulatory scrutiny. If anything, the fact that Moody's can profit from socially destructive activity should be an irrefutable argument in favor of discharging its management team and regulating the business. In other lines of business, people who profit from socially destructive activity are called criminals (think: stealing an old lady's purse).

One rather amazing aspect of Moody's business is their economic research wing. They bought a company run by economist Mark Zandi, who is a very credible economist who, although usually an adviser to Republicans, does serious and respectable research. Like most economists, Zandi is frequently wrong, but he doesn't do nonsense corporate talking points or nonsense fake-research to bolster particular corporations or sectors. But while Zandi was making a very credible case that the U.S. housing market was in trouble, another wing of Moody's business was slapping top ratings on housing securities. Either they didn't believe their own economic research-- in which case, they shouldn't have been putting it out-- or they didn't believe in their ratings. Whichever way Moody's screwed up, their management cannot be seen as anything but corrupt predators.

In other words, management ignored the advice of their own economic research, and ignored it for several years, and made a killing on it. Rating agency profits are not tied to the performance of their ratings-- they're tied to up-front fees they get for making the rating. Those fees are paid not by investors who use the ratings, but by the banks who issue the securities.

That ability to score huge profits regardless of the performance of their own ratings is exactly why Buffett wants to protect the current Moody's management and the current regulatory structure. Moody's team has been very good at securing big profits for the company's shareholders, while sending society off a cliff. Sen. Al Franken, D-Minn., has introduced a bill that would end the conflict of interest between bankers and rating agencies. If that conflict of interest is ended, Buffett's profit machine would be severely impacted. Moody's would have to actually be good at what it does in order to make big bucks.