Poor Standards: 4 Steps to Ending the Rating "Agency" Racket

There's been a great deal of complaining today about Standard & Poor's downgrade of the US government's creditworthiness, but the time for talking about credit rating agencies is long past. There are four steps that can be taken now to end the rating corporations' reign of error.

These "agencies" aren't government entities, but they derive great power from authority conferred by the government. Yet banks and other institutions are allowed to hire the "agency" that rates them.

Picture a situation where the IRS has been "privatized," and taxpayers are allowed to hire the accountants that will review their payments for accuracy. (I know - I shouldn't give them ideas.) Everybody would hire the accountant that says they're due a huge refund, and pretty soon the entire system would collapse. That's not too different from the way the rating game works.

The moment for change was in 2008, when we learned of their key role the global financial crisis. But it's not too late to act now. Here's some background and a clear plan for ending the rating racket once and for all.

Bad Sheriffs

Is it fair to call them a "racket"? Merriam-Webster's definition of a "racket' includes "a usually illegitimate scheme made possible by bribery or intimidation," and "an easy and lucrative means of livelihood." Running a rating agency is certainly the latter. These highly profitable companies enjoy a near-monopoly status that's made possible only because the U.S. taxpayer, through its elected representatives, has given them enormous (and unearned power).

These for-profit companies received their biggest gift in 1975, when the SEC gave three of them - Moody's, Standard & Poor's (S&P), and Fitch's - the new designation of "nationally recognized statistical research organization," or "NRSRO." SInce then, they've been able to use their NRSRO status in much the same way a drunken sheriff uses his badge in a spaghetti western - to bully, intimidate, and cajole themselves into ever-greater positions of power and wealth.

They've been lecturing the US government in a lordly manner [1] for more than a year about the need to make drastic needs to social programs. But ironically (or not), much of the government's current financial problems - and most of the public's problems - are due to a financial crisis they helped make possible through incompetence and moral corruption.

To fully understand the damage these bad sheriffs caused, it's important to understand three things:

1) Federal, state, and local governments, as well as pension funds and other investors, relied on their "AAA" ratings to protect their savings.

2) They traded those AAA ratings to paying customers in return for more business.

3) 90% of the mortgage securities they rated "AAA" in 2007 were later downgraded to junk-bond status.

Oh, and a couple more things:

4) Nothing has changed. Key rating provisions of the Dodd/Frank bill have been delayed and deferred. Why?

5) Because lobbyists for the big three rating "agencies" have spent $1.76 million [2] since January, mostly directed at Congress and regulators.

Poor Standards

Here's what can be found [3] in hundreds of pages of internal "agency" documents released by the Senate last year:

When employees of Moody's were asked what four their highest job goals were, the top three answers were 1) generating more revenue, 2) increasing market share, and 3) good relationships with their customers. Performing high-quality analytical work made the list ... in fourth place. Consultants who performed the survey wrote, "When asked about how business objectives were translated into day-to-day work, most agreed that writing deals was paramount, while writing research and developing new products and services received less emphasis. "

S&P, which has just "downgraded" the United States, was an active participant in the pay-for-play game. When a customer complained about not getting the rating he wanted he was given a better one, but an internal email read: ""I don't think this is enough to satisfy them. What's the next step?"

The customer got what he wanted.

Moral issues aside, these guys are lousy at their jobs. The Treasury Department found a $2 trillion error in S&P's calculations [4]. Among people familiar with their work, this revelation surprised ... well, nobody. What did S&P do with this information? They deleted the error from their report and wrote a different justification for the downgrade - one that relied on unmeasurable "political" considerations.

Did the customer get what he wanted once again?

S&P is very, very protective of its mathematical models. Every report on their website includes this warning: "No content (including ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof may be modified, reverse engineered, reproduced or distributed in any form by any means ..."

Relax, guys. Nobody's reverse-engineering your models - except as comic-relief for overworked spreadsheet jockeys who have watched you manufacture your prefabricated conclusions for years.

Downgrade this!

S&P's agenda has appeared to be political for a long time, and it looks as if its retrofitting its "analysis" yet again to mirror the austerity economics goals of its paymasters.

Last October S&P said the outlook for the Federal government was 'stable' for the foreseeable future, although a Republican victory in the House was widely expected. This April they said the US government needed to address its deficit problem within two years.

Somebody must have repeated S&P's memorable words of yesteryear - "I don't think this is enough to satisfy them" - because then came the next step: Last month they said the government had to find $4 trillion in deficit reductions within 90 days. They had no explanation for their $4 trillion figure, which coincidentally matched the goal being pursued by Democratic and Republican negotiators at the time.

The government has just conclude a deal that provides $2.5 trillion in (very unwise and unfair) reductions. Buckle your seatbelts, numberphobes, becomes here comes the math: $2.5 trillion (in debt-deal cuts) plus $2 trillion (overstatement of deficit by S&P) = $4.5 trillion. (Hey, modeling is my life.) That's half a billion more than the number S&P wanted. They downgraded anyway.

As you marvel at my proficiency in simple arithmetic - a skill apparently unreplicated at the rating "agencies" - please note this warning: "No content in this blog post (ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) may be modified or reverse engineered in any form by any means ..."

That means you, S&P!

"A little less conversation, a little more action"

Tim Geithner's right to call these guys out for incompetence, but the Elvis lyric quoted above is as relevant today as it was in 2008. And so is the line that follows, politically speaking: "All this aggravation ain't satisfactioning me." Here are four steps that can be taken to end the agency racket right now:

1. Strip Moody's and Standard & Poor's of their NRSRO status on the grounds of egregious professional errors and ethical lapses.
2. Announce an SEC policy requiring any future NRSROs to be educational institutions or nonprofit agencies. Provide a proper time frame - two years sounds right - to get these agencies up and running, and provide them with logistical and financial support.
3. Government law currently protects these "agencies" from being sued by defrauded investors. Lift that protection immediately - and make sure that executives and officers are personally liable for fraudulent acts. (Nothing clarifies the mind like the risk of a lawsuit.)
4. Eliminate "pay to play" immediately by borrowing an idea from the Franken Amendment. Here's how: Automatically assign an agency to conduct a review, rather than allowing the institutions being reviewed to hire one themselves.

This is bound to be a smart political move, since it will give those much-coveted independent voters what Elvis would call "A little more bite and a little less bark, a little less fight and a little more spark."

Oh, and it could save the economy, too. That has to be worth something too, even in this era of reality-free politics.