Why the SEC Should Get Medieval With the Credit Rating Agencies

Biblically epic financial crisis on your hands? Fear not! The SEC is on the case. The agency is hot on the heels of credit rating agencies, which -- perhaps you heard -- may have had something do with the housing crash:

Now, SEC officials are focusing on the question of whether the ratings companies committed fraud by failing to do enough research to be able to rate adequately the pools of subprime mortgages and other loans that underpinned the mortgage-bond deals, according to people familiar with the matter.

But what did credit rating agencies do that was so wrong? Hey, glad you asked. Their cardinal sin, which lies at the heart of what the SEC is investigating, was that they willfully ignored that the nonprime loans investment banks were packing like gunpowder into mortgage-backed securities and collateralized debt obligations were -- oops, there's that word -- fraudulent. Then the ratings firms stamped them "AAA."

Credit raters knew not to know
As Sens. Carl Levin, D.-Mich., and Tom Coburn, R.-Okla., documented in April, there is by now no doubt that the credit rating agencies were well aware that the borrowers who had taken out the loans backing these securities would never be able to pay them back. The evidence was copious. Historically, AAA-rated securities almost never defaulted, for instance. But as the housing bubble was deflating, the large majority of these investments either experienced big losses or went completely up in smoke. The Senate permanent subcommittee on investigations concluded:

From 2004 to 2007, Moody's and S&P knew of increased credit risks due to mortgage fraud, lax underwriting standards, and unsustainable housing price appreciation, but failed adequately to incorporate those factors into their credit rating models.

Only in part. The complete answer is that ratings firms didn't want to know that by 2006 something like half of all subprime loans consisted of "liar's loans" and that the overwhelming majority of those were fraudulent. S&P and Moody's willfully chose not to examine the quality of these loans in assigning ratings. If they had, they would've been obliged to alert banking clients that their securities were, in effect, a scam. Then the raters wouldn't have gotten paid. The soaring revenues the firms had enjoyed over the previous five years, fueled by an explosion of business evaluating structured finance products, would've come to an abrupt end. Executive bonuses would've vaporized.

By contrast, turning a blind eye to the bogus loans allowed the firms to continue bestowing investment-grade ratings on MBS and CDOs even after the mortgage market had started disintegrating.

Drawing a line
Fraud, like porn, may be hard to define, but you tend to know it when you see it. Proving it in court, admittedly, is a taller order. And just because the SEC is sniffing around the credit rating agencies doesn't mean justice will finally be served, given the federal government's timidity in prosecuting parties implicated in the financial crisis. Although Goldman Sachs (GS) paid a significant fine to settle the agency's suit over its CDO practices, after all, the bank only copped to making mistakes, not to swindling investors.

That's not good enough. The ratings firms deserve real punishment, not out of some Old Testament desire for retribution, but because the goal of repairing our financial system demands it. Blame must be assigned, guilt admitted. The boundary between business and fraud must be visible to all.

Related:

• How the Credit Rating Agencies Favor Celebrities
• As Obama Enacts Financial Reform, Credit Rating Agencies Fight to Remain Above the Law
• Financial Reform: Why Do the Credit Rating Agencies Still Live?
• Bad Credit: How S&P, Moody's and Fitch Helped Cause the Housing Bubble
• Congress Too Soft on Credit Rating Agencies