Seeing Through Data

Tuesday, Abigail Field and I published a piece breaking down the performance of an S&P rated sub-prime bond, Standard & Poor’s Standards Left Investors Poorer.

Yesterday the Attorney General of IL, Lisa Madigan, filed a lawsuit against S&P for this very behavior.

The complaint contains internal email and IM messages; they’re not new, but they paint a portrait of an organization that intentionally and recklessly led the world economy off a cliff.

I won’t repeat the earlier S&P post except to point out that while directing vitriol towards Standard & Poor’s, and the other ratings agencies, is nothing new, the timing of these lawsuits is only now becoming germane.  That is because the top “AAA” rated tranches are just now reaching their lowest tiers, the one’s that were safer than US debt, and never supposed to fail.

Remember, the way these securities were structured: investors purchased different groups of loans, called tranches.  Some investors were supposed to take the first losses, and others the latter losses.  There were three groups and losses were never supposed to extend to the top group because even in a catastrophic loss scenario the lower tranches would insulate investors.

Even with the brutal meltdown in housing most top-tranche mortgage-backed securities have held up relatively well .. until now.  Now the lower tranches are gone, the top 2/3rds of the higher-rated tranches have been paid off (often with no losses, as expected) but the bottom 1/3rd tranche — the best loans — is certain to take losses which S&P predicted were never supposed to occur.

Here are some choice excerpts from the lawsuit that make it clear how much S&P believed their own ratings, and what was their actual driving force:

“.. improving (the accuracy of) the model would not add to S&P’s revenues.”  Email, 3/23/2005.

“Let’s hope we are all wealthy and retired by the time this house of cards falters.”  Email, 12/15/2006.

“We found from the arranger that our support level was 10% higher than Moody’s .. the only way to compete is to have a paradigm shift in thinking..”  Email, 5/24/2004.

“I would recommend we do something [u]nless we have too many deals in the US where this could hurt…” Email, 5/24/2007.

“Lord help our fucking scam … this has to be the stupidest place I have worked at.”  Email, date unknown.

“I am extremely afraid of the seeds of destruction the financial markets have planted… I have been a mortgage broker for the past 13 years and I have never seen such a lack of attention to loan risk. I am confident our present housing bubble is not from supply and demand of housing, but from money supply…”  6/27/2005 email from a mortgage broker to S&P.

Then there’s this April, 2006 IM chat between two employees:

Rahul: btw – that deal is ridiculous
Shannon: i know right .. model def does not capture half of the ris[k]
Rahul: we should not be rating it
Shannon: we rate every deal
Shannon: it could be structured by cows and we would rate it
Rahul: but there’s a lot of risk associated with it – I personally don’t feel comfy signing off…

These communications came to light during federal investigative hearings.  S&P has been sued, and has successfully defended itself claiming “free speech,” which seems analogous to a doctor claiming a freedom of speech right to write the wrong medicine on a prescription pad as a defense to the resulting malpractice lawsuit.

Politicians have vowed to do something but, of course, they haven’t followed through in any substantive manner.

This past summer S&P downgraded US debt after the government failed to meet their demands on spending, as if an incompetent and arguably crooked ratings agency has the right to dictate US fiscal policy to the elected leaders of the world’s largest economy.  During that time Treasury pointed out that S&P made a $2 trillion math error, which S&P corrected then downgraded the US debt anyway.

While nothing is likely to happen to S&P in court or through legislation the post-US debt downgrade behavior is telling: investors entirely ignored S&P’s opinion.  Demand for US debt continues to be considered so safe — safer than many other potential S&P AAA rated investment opportunities — that investors actually pay to purchase US debt.

This is likely to be the conclusion of the S&P saga, along with the other ratings agencies who are effectively just as bad: they lost credibility and investors no longer listen to them.  Since investors typically do not have the knowledge to individually rate each deal it’s apparent they’re ignoring the ratings.

Investors are investing in items like US Treasury debt, which is good for the Treasury but lousy for private businesses that need to sell their own securitized debt to thrive, but can’t in some part due to a well-founded lack of trust in the assigned ratings.

At least one start-up, R&R Consulting, co-founded by industry vets Anne Rutledge and Sylvian Raynes, are disgusted at the status quo and have announced plans to ramp-up a new ratings agency.  I’ve never spoken to them though I can see that many staff members were taught by the same faculty that help me analyze my own data.  I’m sure that they’re top-notch people; competent and, for a nice change, ethical, and I wish them well.

Because of the difficulty with the free speech argument Attorney General Madigan has an uphill road to climb, but it’s encouraging to see her willing to take on the task.