Michael Lewis and David Einhorn had an op-ed in the NYT on Sunday that is worth reading. Their piece draws attention to two inter-related aspects of the meltdown in the financial markets.
First, there is the role of the SEC:
Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question,
intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)
The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.
IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.
The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.
At the back of the version of Harry Markopolos’s (sic) brave paper currently making the rounds is a copy of an e-mail message, dated April 2, 2008, from Mr. Markopolos to Jonathan S. Sokobin. Mr. Sokobin was then the new head of the commission’s office of risk assessment, a job that had been vacant for more than a year after its previous occupant had left to — you guessed it — take a higher-paying job on Wall Street.
At any rate, Mr. Markopolos clearly hoped that a new face might mean a new ear — one that might be receptive to the truth. He phoned Mr. Sokobin and then sent him his paper. “Attached is a submission I’ve made to the S.E.C. three times in Boston,” he wrote. “Each time Boston sent this to New York. Meagan Cheung, branch chief, in New York actually investigated this but with no result that I am aware of. In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violations.”
Sokobin was no more willing to rock the boat than people before him had been. Presumably, he had the same retirement plan.
Lewis and Einhorn, for some reason, do not name names, but the “commission’s most recent director of enforcement” who is the general counsel at JPMorgan Chase is Stephen M. Cutler; the enforcement chief before him who became general counsel at Deutsche Bank is Richard Walker; and the predecessor who became a managing director for Credit Suisse before moving on to Morgan Stanley is Gary G. Lynch.
Lynch was the Director of the Enforcement Division at the SEC from 1985 to 1989, Walker from 1998 to 2001, and Cutler from 2001 to 2005.
Then there is the role of the credit-rating agencies:
Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.
Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, “If you put one more risky asset on your balance sheet, you will face a serious downgrade.”
The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s.
These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.
This is a subject that might be profitably explored in Washington. There are many questions an enterprising United States senator might want to ask the credit-rating agencies. Here is one: Why did you allow MBIA to keep its triple-A rating for so long? In 1990 MBIA was in the relatively simple business of insuring municipal bonds. It had $931 million in equity and only $200 million of debt — and a plausible triple-A rating.
By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.’s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.
Yet the rating agencies didn’t so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn’t deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: “Is MBIA Triple A?” (The answer was obviously no.)
At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA’s guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA’s failure became such an open secret that nobody any longer cared about its formal credit rating.)
The key role of the ratings agencies in enabling the financial markets meltdown has been underlined before, of course. But it doesn’t seem to have drawn very much attention. And Moody’s and Standard & Poor’s have got away scot-free, pretty much, for what is clearly not just a bunch of honest mistakes but a coldly calculated extended fraud that is surely even more outrageous and deserving of investigation and punishment than Madoff’s Ponzi scheme. In fact, Madoff’s fraud looks petty in comparison.
As the MBIA example makes clear, Moody’s and Standard & Poor’s deliberately falsified investment grade ratings for instruments and companies that were far from investment grade. And it is this falsification of ratings that enabled all those banks to load up so heavily on all that worthless paper, creating the situation that led to the financial market meltdown, the situation that will probably end up costing taxpayers much more than a trillion dollars by the time all the dust has settled. And Moody’s and Standard & Poor’s did this for what? So that there would continue to be a flourishing market for new instruments that they could continue to earn revenues from? For a few paltry pieces of silver?
Partly, of course, they got locked into their fraud, just as a Ponzi scheme operator gets locked into his. As Lewis and Einhorn point out, inflated ratings quickly came to constitute an intricate, interlocking house of cards. Starting to re-rate one class of securities or companies would have had a domino effect, leading to wholesale re-rating for most of the mortgage-backed securities market, and all the banks who were heavily invested in it, and all the insurers who had insured those securities, and all the companies who were insured by those shaky insurers, and so on.
So they buried their heads in the sand, and continued to churn out those laughable investment grade ratings, and collect their few pieces of silver.
