Judge Doesn't Believe S&P That No One Believed In Its Ratings

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The judge hearing the Justice Department's CDO-rating lawsuit against S&P refused to dismiss it yesterday, rejecting S&P's much-mocked theory that its pre-crisis claims of independence and objectivity and, like, plausible ratings were just "puffery" that no one should have taken seriously. Here is the story, and here is his opinion, and here is a rhetorical question:1

At the hearing on this matter, Defendants repeatedly asserted that no reasonable investor would have relied on S&P’s claims of independence and objectivity. Regarding the question of materiality, S&P argued that, since the issuer banks had access to the same information and models that S&P analysts did, they could not have been fooled by faulty credit ratings. This begs the question: if no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting that, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness?

Well so I mean do you want an answer? How much value do you think they added?

The S&P case is a pretty weird beast because it's brought under the FIRREA, a law designed to protect federally insured banks, and so the government has to assert that:

  • S&P lied about the goodness of its process to rate RMBS CDOs;
  • they did so to obtain money for S&P from those CDO investor banks;
  • CDO investors that happened to be banks believed those lies; and
  • the goodness or badness of that process mattered to the CDO investor banks.

The first part is pretty clearly true! S&P said a lot of "our ratings are not influenced by commercial considerations" while letting commercial considerations influence their ratings. The second part is pretty dicey, since the whole problem with S&P's model was that it was an issuer-pays model, so the CDO investors never paid S&P a dime. There's a not entirely satisfactory answer to that.2

The third and fourth parts are the core of S&P's defense, and they're right, it is pretty weird: why would anyone believe that S&P's ratings were not influenced by commercial considerations? I mean, one, it just seems self-evidently unlikely that a company that competes to sell a product to a small group of customers wouldn't care what the customers think about the product. But there's an even better argument, which is that the CDO-investor-bank victims of S&P include a lot of those issuer customers. As Jonathan Weil pointed out when the case was filed in February:

For nine of the CDOs, the government’s complaint listed Citigroup as the harmed investor -- without mentioning that Citigroup’s investment-banking division had managed the bonds’ offerings. The complaint identified Bank of America as the defrauded CDO investor in two instances, also without mentioning that its securities unit underwrote those bonds.

It’s a novel concept. If only S&P had given honest opinions to Citigroup and Bank of America -- which were paying S&P millions of dollars for ratings -- then the banks would have realized they were buying ticking time bombs from themselves.

Now, look, it's possible. Maybe Citi and BofA believed in S&P's total objectivity, never shopped around for the highest rating or pushed back on models, thought they were paying a fair fee for a fair rating, and were just pleasantly surprised when whatever they had came back rated AAA. But it seems unlikely. It's hard to attribute thought across the diverse collection of minds that is a bank, and it's entirely possible that a treasury-type arm of Citi bought Citi-underwritten CDO tranches without talking to the underwriting desk, but I suspect that at the very least the guys building the CDOs for Citi had, y'know, actual experience steamrolling S&P.

So why'd they buy the CDOs? Maybe Citi independently thought they were a good investment proposition - I mean, they underwrote them, after all - but leaving that aside: why get them rated? To sell to others, sure, but also because the rating mattered for capital purposes. AA/AAA RMBS CDOs got 20% risk weighting, versus 50-100% for whole mortgages. Ratings, for these banks, weren't a matter of credit analysis; they were a matter of box-checking and capital optimization.

Given that explanation, if the ratings were wrong, and wrong for nefarious reasons, you can see why the DoJ would be pissed. And why they'd sue S&P under the don't-mess-up-insured-banks law. That's exactly what it's supposed to be for! Punishing people who, to make a buck, do sneaky things that make insured banks less safe. The mechanism might be "AAA ratings cause banks to believe CDOs are safe and so they buy them," or far more likely it might be "AAA ratings cause CDOs to be attractive for capital purposes and so banks buy them," but from the perspective of "should the government be pissed?" that's irrelevant.

On the other hand, from the perspective of "is this a fraud perpetrated on the banks?," it seems pretty relevant? If the CDO-buying banks, CDO-selling banks, and ratings agencies all had incentives aligned to have risky things rated AAA, then it was irrelevant to the banks whether the ratings process was independent and objective or venal and sloppy. The relevance of S&P's objectivity or lack thereof was to regulators, who might well have been hoodwinked by a Code of Conduct on S&P's web page. And who are understandably pissed. But "you fooled the banking regulators" is a less palatable case, if for nothing else than for embarrassment reasons, for the DoJ to bring.

When S&P first raised its "puffery" defense, people pointed out that S&P was currently - in 2013! - running ads, in places like the Wall Street Journal and the Kudlow Report, touting how objective and independent its ratings are (now!).3 Hahaha gotcha but of course no one buys CDOs from the Wall Street Journal or the Kudlow Report. Or, God knows, from S&P's statements of principles on its web page. People buy bonds from offering memos.4Here's a famous one and it does precisely zero puffing of the credit ratings. Quite the opposite:

It is a condition to the issuance of the Notes issued on the Closing Date that the Notes of each such Class receive from the Rating Agencies the minimum rating indicated under "Summary—Notes". A credit rating is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agency.

That's about it! "There will be ratings, but don't believe them."

So why advertise in the Journal? Why have a code of conduct on your web page that has a lot of blather about your objectivity and independence and ability to ignore the demands of your paying customers? Who are you trying to convince? I submit to you that exactly one sort of person reads codes of conduct on web pages, and that's the sort of person we call "regulators." If you're in a business that exists largely because of regulatory quirks, you want relentless PR and warm feelings from the regulators. The investors can take care of themselves.

Judge Slams S&P's Defense in U.S. Lawsuit [WSJ]
U.S. v. McGraw-Hill Companies - Order Denying Defendants' Motion to Dismiss [via WSJ]
Earlier: S&P: Obviously No One Thought Our Ratings Were Objective Or Unbiased Or, For That Matter, True

1.And here is the footnote where I vainly try to hold back the tide on "begs the question," at least in legal opinions, oh well.

2.Which is:

S&P knew this scheme to defraud would result in S&P obtaining funds directly from the investors who were fooled by their ratings, since S&P charged its ratings fees to CDO issuers and “those issuers ordinarily did not bear the cost of the ratings fees. Instead, as S&P knew, the costs of those fees were passed through to the investors who purchased CDO tranches.” The alleged motive for doing so was “to maintain and increase its share of the market for credit ratings of RMBS and CDOs and the high fees and profits those ratings generated.” Finally, the complaint alleges that S&P’s executives knew of this investor-pays arrangement, quoting comments made by Joanne Rose, S&P’s head of Structured Finance, to a group of institutional investor representatives, that “undefinednvestors need to publicly voice their opinions on issues like the issuer pay model—investors ultimately do pay—since all deal fees including rating fees are netted out of the total deal proceeds.”

Do you read that to mean "100% of the incidence of ratings fees is on investors, not issuers"? Does that seem true? (What would it mean?) Etc.

3.Here is BuzzFeed:

Unfortunately, commercials that S&P is running on shows such as Sirius XM’s “The Kudlow Report” — a radio version of CNBC host Larry Kudlow’s TV show — seem to at best contradict, and at worse undermine, its legal position.

Over a sentimental score, a narrator’s voice could be heard summarizing the importance of the agency’s credit ratings and how S&P’s research is “in-depth” and the result of exhaustive internal study.

“Our analysts conduct in-depth research, and their ratings are scrutinized before being approved by a committee process,” the commercial assured Kudlow’s audience, made up primarily of traders and investors. “The resulting ratings help capital markets develop and function smoothly, which means more resources for businesses to grow and create jobs. The fact is, we’re proud of our work and the people behind it, and we’ve taken to heart the lessons learned during the financial crisis, improving and refining the methodologies behind our ratings.”

Far from “puffery,” the commercial essentially begs listeners to take S&P seriously.

I mean, no, that is puffery. "We're proud of our work and the people behind it": like, the definition of puffery. Do you think they're really proud of their people? Like, everyone at S&P is proud of everyone else at S&P? Etc.

4.Well obviously that's false. But it's, like, a legal fiction.