A pal of mine in Washington, keeping watch on the legislators and regulators, is asking what to name his pied-a-terre, with its balcony facing the nation’s capitol.
With a familiar old blame game now roiling in the credit markets, we’re suggesting he call the place “Déjà Vu.”
It’s not only Enron all over again for the beleaguered banks that wrapped up and sold the exotic mille-feuilles of debt securities concocted out of subprime mortgages. It’s even more ominous for the three dominant credit rating agencies – Standard & Poor’s, Moody’s and Fitch – under scrutiny for their own multiple and well-compensated roles.
To summarize: this trio advised on the creation and design of these complex instruments. They then proceeded to issue their ratings on the same paper, which was peddled around to hedge funds, local government cash managers, and institutional investors worldwide. The ratings – required by the offerors to be of defined grades -- were carefully couched as “opinions” strictly limited to credit risk. Yet they were viewed by the purchasers not only as measuring expected credit loss, but as proxies for over-all investment quality. That is, they were issued under a “but-for” test: no rating meant no deal.
But reality eventually intruded: no established markets meant that nobody really had a clue about the value of these one-off instruments – not the buyers, not the issuers who paid for the ratings, and not the ratings agencies themselves.
Any wonder at the intensity of the heat? With cries of “conflict of interest” ringing loud, the ratings agencies are assailed across the globe, from EU markets commissioner Charlie McGreevy to the Attorneys General of Ohio and California. And along with the issuing banks, they are being named in lawsuits by their own shareholders and investors as well.
Should any of this feel surprising? Whatever the defensive spin and the persistent denial of the deepening conditions of adversity, problems yet to ripen mean that we are not yet even approaching what Winston Churchill termed the “end of the beginning.” Still to come in the next year or so:
• Upward interest rate re-sets on the subprime mortgages themselves, ballooning the homeowners’ payments and default rates and deepening the gloom in the housing sector.
• Legislators’ tinkering for the sake of the poor homebuyers, with uncertain but real effects on the value of the investment portfolios where the mortgages came to reside.
• Exposure during this audit season of the still-hidden skeletons in the closeted portfolios of the institutional investors who are still exploring and discovering their exposures.
• Further blood-letting in the executive suites, as the blown-up careers of Merrill’s Stan O’Neal, Citigroup’s Chuck Prince and Bear Stearns’s Jimmy Cayne foretell a parade of CEO sacrifice.
• And finally, several more rounds of loss provisions – witness the $24 billion at Merrill and the three-stage total of $18 billion at UBS -- as the subprime debt-holders struggle, along with their auditors and lawyers, to supplant their discredited valuation models and mark their positions to market reality.
Eventually these will play out. But dozens of new lawsuits already disprove the claim of the academic scorekeepers, that the post-Enron dip in the case-count represented a systemic cleansing of the corporate stables. The bad old days are indeed here again – Sarbanes-Oxley was never to be a one-time fix for corporate financial misbehavior.
Ratings agencies confronting their antagonists have historically invoked the virtually sacred American right of free speech. But the security blanket of the First Amendment must be feeling threadbare, limited as is its coverage to the journalistic role of publicizing ratings data at no cost to the end-using consumers.
Rather, critics point to the three large ratings agencies’ cartel control of the sector, their allegedly corrupting consulting practices and client-based fee structures, their opaque opinions, and above all their inability, under market stress, to foresee or prevent their clients’ financial debacles.
The agencies themselves are touting a menu of fixes, from Moody’s proposal to replace letter ratings with numbers – arguably no more than a switch from illiteracy to innumeracy – to massive downgrades of mortgage-backed securities with knock-on effects for other debt portfolios and the entire bond insurers speciality, to the blame-the-user invocation by Standard & Poor’s of more “investor education.”
But should the ratings agencies feel confident of dodging the bullets? Two lessons in history suggest not. First, the closely analogous model of the auditors’ participation in the securities marketplace has brought them to grief, with multi-billion dollar litigations threatening their very survival. Second, both plaintiffs’ lawyers and legislators, inspired by Sarbanes-Oxley, will pick on proximate targets. That’s where they will both fix the blame and aim their fire.
So once again, the phrase “It’s different this time” can be chiseled on the gravestones of those who speak it. In fact, it’s the same all over again.
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