Senator Warren asks why

Senator Elizabeth Warren recently wrote a letter to the Inspector General of the Department of Justice in which she asks why DOJ did nothing with the referrals of the Financial Crisis Inquiry Commission that securities laws were violated in the lead-up to the Great Recession. Here are some excerpts from that letter: 

They detail potential violations of securities laws by 14 different financial institutions: most of America’s largest banks — Citigroup, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Washington Mutual (now part of JPMorgan), and Merrill Lynch (now part of Bank of America) — along with foreign banking giants UBS, Credit Suisse, and Société Generale, auditor PricewaterhouseCoopers, credit rating agency Moody’s, insurance company AIG, and mortgage giants Fannie Mae and Freddie Mac.

The FCIC presented the DOJ with evidence that these institutions gave false representations about the loan quality inside mortgage-backed securities; misled credit ratings agencies; overstated assets and earnings in financial disclosures; failed to disclose credit downgrades, subprime exposure, and the financial health of their operations to shareholders; and suffered breakdowns in internal company controls. All of these were tied to specific violations of federal law.

And the FCIC named names, specifying nine top-level executives who should be investigated on criminal charges: CEO Daniel Mudd and CFO Stephen Swad of Fannie Mae; CEO Martin Sullivan and CFO Stephen Bensinger of AIG; CEO Stan O’Neal and CFO Jeffrey Edwards of Merrill Lynch; and CEO Chuck Prince, CFO Gary Crittenden, and Board Chairman Robert Rubin of Citigroup.
None of the 14 financial firms listed in the referrals were criminally indicted or brought to trial, Warren writes. Only five of the 14 even paid fines in civil settlements. None of the nine named individuals were criminally prosecuted, and only one — Crittenden, of Citigroup — had to pay so much as a personal fine, for a mere $100,000.

Credit Rating Agencies Again

The SEC issued its annual report on credit rating agencies last month. And it's not good. It does not seem as though the agencies have changed their way of working very much. For example, the report says that two of the larger companies “failed to adhere to their ratings policies and procedures, methodologies, or criteria, or to properly apply quantitative models.”

We all make mistakes, but the agencies don't tell anyone about theirs or their implications. And then some agencies outright lie. They do not accurately describe the methodology used to determine some of its official grades. Statements made in rating publications directly contradict internal rating records. Management has a say in the final rating, sometimes it is to change the original rating by the staff. Of course, is there anything wrong when the agency gives an unsolicited rating to an issuer?

The agencies really helped create the Great Depression. It looks like they are trying to repeat.

Repeating 2008?

This is from a post of mine from August 2013:

One of the major causes of the Great Recession was the failure of the ratings agencies (S&P, Moody's, Fitch) to properly rate securities.  In order to secure business the agencies did not publish unbiased ratings; they gave AA ratings to securities that should have been unrated or D.  It looks like this practice is starting to return.   

Well, the practice has definitely returned. One measure is the number of analysts who have moved from the credit-reporting agencies to investment bankers.  SEC records show more than 300 have done so since 2008. That's in a universe of 4,000 analysts. So, about 7.5% of credit-reporting analysts have gone to the companies who issued the securities these analysts rated. And, it looks like the number is increasing as 80 moved in 2014.

Since there is no rule establishing a waiting period for analysts moving to a company you were rating, the question becomes: can credit analysts be impartial about grading bonds while looking for employment at banks that underwrite them?

A study by some academics found that "when an analyst is hired by one of the top 20 banks, rankings rise by 0.35 level on average compared with an average 0.18 grade increase for all analysts switching positions. If that bump-up elevates the bond to investment grade from a speculative, or junk, rating, the borrower would save $85 million in interest over the life of a $1 billion 10-year bond, according to data compiled by Bloomberg."

Is she worth $7,000,000?

The president of RPI, Shirley Ann Jackson, was paid over $7,000,000 in 2012. Plus, she was housed in a large mansion, traveled first class and had a chauffeured luxury car to transport her around the campus. She must be fairly talented as she is on the board of IBM, Marathon Oil and a few other companies. So, financially she seems to be well set even though RPI is not a football power.

But under her, RPI's debt ran up to $828 million―over six times its level when she took office. Moody’s has downgraded RPI’s credit rating twice, and describes the financial outlook for RPI as “negative.” She seems to be against labor; she abolished the Faculty Senate and stymied attempts to unionize. For whatever reason, RPI's tuition is far above the average of New York's four year colleges: $45,100 versus $25,608.

What really intrigued me was a set of rules she has established:
1) Only she is authorized to set the temperature in conference rooms; 
2) Cabinet members all rise when she enters the room; 
3) If food is served at a meeting, vice presidents clear her plate; and 
4) She is always to be publicly introduced as “The Honorable Shirley Ann Jackson.”

The real Chris Christie?

It's interesting but not surprising that the media has said very little about Chris Christie's accomplishments as governor.  John Atlas and Peter Drier try to fill that knowledge gap, as they argue that Christie is very close to Tea Party Republicanism.  Here is their indictment:

Wounding the economy: New Jersey has the nation's seventh highest unemployment rate and the second highest percentage of mortgage loans in foreclosure. New Jersey's credit rating has dropped on Christie's watch.
Hurting the poor and middle class: Christie reduced the earned-income tax credit, a popular program that helps lift the working poor out of poverty - in other words, he raised taxes on the poor. Christie vetoed a minimum wage hike that the legislative had passed, calling it "stupid" and "truly ridiculous."
Enriching the rich and big business: While stiffing New Jersey's poor and its middle class, Christie has handed big corporations more than $2 billion in tax breaks that has had little impact on job creation.
Wasting tax money to boost his political career: Christie siphoned off millions in federal relief funds intended for Hurricane Sandy victims in order to pay for television ads that promoted himself, prompting a call for a federal investigation.
Opposing women's equality and rights: By cutting $7.4 billion targeted for Planned Parenthood, Christie shut down six family planning clinics that provide cancer screenings, contraception, and other essential women's health services. He vetoed a bill to prevent gender wage discrimination in public contracts, calling it "senseless bureaucracy."
Opposing same-sex marriage: Christie vetoed a bill to give equal rights to gay couples.
Damaging the environment: Christie defeated a push by 180 environmental organizations to let New Jerseyans vote on a ballot measure to increase parks, and other open spaces. He also pulled the state out of a regional agreement to reduce greenhouse gas emissions by 10 percent by 2018. He plans to divert $40 million from a recent settlement with Passaic River polluters intended to restore the blighted waterway to balance the state budget.
Opposing affordable health care: New Jerseyans trying to enroll for Obamacare face difficulties not encountered by New York residents because unlike Governor Cuomo, Christie refused to create a state health insurance exchange.
Attacking public education and public employees: Like Wisconsin's Gov. Walker, he has used the state's public employee unions as a political punching bag. He cut health and pension benefits for public sector workers.

In his first year as governor, Christie slashed $1.2 billion from the state's public schools - cuts that the state Supreme Court said violated students' rights. He killed a DREAM Act bill that would provide in-state tuition at state colleges for the children of immigrants who graduate from New Jersey high schools. Meanwhile, he cut funding for higher education by 15 percent.
Opposing affordable housing: Despite a severe shortage of low and moderate-income housing, Christie tried to divert funds earmarked for affordable housing until the courts blocked him from doing so.
Compromising civil rights and criminal justice: Christie declined to renominate Associate Justice John E. Wallace Jr, the only African-American on the New Jersey Supreme Court, and left vacant over 50 seats on New Jersey courts.

I've heard this song before

New York has a reputation for having the highest requirements for insurance companies to do business there.  So, I guess it's to be expected that it would raise a warning flag about the growth of captive reinsurance.  

Reinsurance has long been recognized as a sound policy for insurance companies, as there is no FDIC for insurers as there is for banks.  Until recently, reinsurance deals have been negotiated at arm’s length by independent companies; both sides understand the risk and agree on a fair price for covering it. The obligations drop off the original insurer’s books because the reinsurer has picked them up.  Captive reinsurance is quite different; the risk is not transferred to an independent reinsurer; it is transferred to a subsidiary of the insurer. Thus, the deal is not at arm’s length. Because the risk is transferred to a subsidiary it is difficult to know what the deal really is.

Like the structured mortgage deals that played a large role in the Great Recession, captive insurance deals are quite complex.  It took the New York regulators nearly a year to follow the paper trail, even though they had the power to subpoena documents.  And, like the structured mortgage deals, the companies say there is nothing to worry about.  

MetLife says that it “holds more than sufficient reserves to pay claims on its policies” and added that it used reinsurance subsidiaries “as a cost-effective way of addressing overly conservative reserving requirements” for certain insurance products. If it had to set aside that level of reserves more conventionally, it says, it would either have to borrow — putting its credit rating at risk — or raise the money by selling stock, dragging its returns below the level its stockholders require.  The New York regulators say, “Those practices (re structured mortgages) were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices.  And ultimately, those practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multitrillion-dollar taxpayer bailout.”

New York contends that these deals allow the companies to describe themselves as richer and stronger than they otherwise could in their communications with regulators, stockholders, the ratings agencies and customers, who often rely on ratings to buy insurance.

Interestingly, these deals do not seem to be as enticing to mutual companies as they are to publicly traded companies.  Why do you suppose that's so?

Finally, the ratings agencies may have a problem

Surprise, surprise!  DOJ actually filed charges against a credit-rating agency, S&P.  True, it's only for civil, not criminal, fraud, but it may be a start.  And it is expected that some states will be joining the suit.  S&P is also being investigated by the SEC.

Interestingly, the government is pressing the firm to plead guilty to at least one count of fraud.  This is very different from the government's willingness to allow fraudsters to neither admit nor deny guilt.  Who knows maybe they'll even try to put someone in jail?

It Works on a Small Scale

Family Independence Initiative (FII) offers a new approach to getting people out of poverty. Notice that I did not use the word 'helping'. That's because FII's basic premise is that the poor can get themselves out of poverty.

What FII does is provide a structure. The word 'Family' in its title is one of the keys if you use its plural form, families. FII organizes small groups of families and gives them an opportunity to better themselves by using the talents, ideas and strengths of the families. A group is very goal-oriented. FII asks the group to write down its goals as a group, as a family, as an individual. When a goal is met, FII pays $30 (there is a maximum of $200 per month). FII supplies a computer so that they can fill in a monthly questionnaire devised by FII; the question tracks changes in their lives, such as income, debts, health, community endeavors, etc. The answers in the questionnaire are audited every three months.

In addition to setting their goals, each family meets at least monthly with the other families in their group to discuss goals and whatever else they think important. These monthly meetings are not organized by FII. Nor are they run by FII. In fact, FII does not even provide any advice to the group. Maurice Lim Miller, the founder of FII, says, "What we’re going to do is give you some resources and connections and we’re going to trust that you’ll do something,” he said. “You guys are in the power position. If you do nothing we’ll fail. If you do something we’ll all learn.”

Here's what FII says the results have been in Boston:

In June of 2010 152 individuals, including 81 children, from 35 families enrolled in FII’s Boston demonstration project. In just six months by working together they made tremendous progress toward the goals they set for themselves. Outcomes include:

• 13% increase in average household income (excluding subsidies and FII payments)
• 22% increase in average savings
• 25% of children improved grades
• 20% improved attendance

The families are pursuing a range of initiatives to move forward and are focused on quality of life issues like more time with their kids, for themselves, building relationships, better access to food, self care, and education. The families reported over 500 initiatives and positive “sparks” from June to December of 2010. Families are also taking steps to raise their credit rating by getting financial counseling, paying bills on time, and reducing debt.

Similar results have been achieved in San Francisco, Oakland and Hawaii. It appears as though this is not a get-rich-quick scheme or an attempt to exaggerate results.While the NY Times has been wrong before, there is a feature article on FII in today's paper.

Would it work on a large scale? I have my doubts, but, on whatever scale it does work, it is helping people and this country.

Negligent Homicide

Image by Getty Images via Daylife

Ross Levine of Brown University has performed an 'autopsy' of the Great Recession and concludes that 'negligent homicide' played an important role in the demise. By negligent homicide Levine is referring to the silence and inactivity of the regulatory agencies in the late 1990s and early 2000s. In Levine's opinion, these agencies - mainly the Fed and SEC - and Congress designed, implemented and maintained "policies that spurred excessive risk taking and the eventual failure of the financial system". He is not saying that greed and overly complex financial products did not play a role in the failure, but they would not have been able to play that role if the regulators had done their jobs. The regulators knew that problems were looming, however they did nothing to prevent them.

The first agency Levine looks at is the SEC and its decision to establish Nationally Recognized Statistical Rating Organizations (NRSRO), which essentially meant anointing Moody's, S&P, Fitch etal as gatekeepers to the securities markets. The SEC used the ratings of the NRSROs to establish the capital requirements for institutions the SEC regulated. Eventually, these ratings became de rigeur for any company that wanted to play in the big leagues. At heart, the NRSROs were given the "right to sell license to issue securities". The money for these licenses was quite good and the rating agencies succumbed to the temptation. If you paid enough money, you got the rating you wanted. Is there any wonder that so much garbage was rated AAA? Did the SEC do anything to get the NRSROs to produce realistic ratings?

The Fed is the next agency Levine looked at. He considers the effect of the Fed's decision in 1996 to allow banks to use credit default swaps to reduce their need for capital, which enabled the banks to invest in higher-risk situations. The Fed did not keep a close watch on the derivative markets, although in 1992 the NYFRB noted their concerns about the markets and did threaten to do something about them. And in 2004 my friend, Tim Geithner, as head of the NYFRB, was concerned about the lack of information on these swaps. Plus the Fed was aware that the subprime mortgage market was getting shakier. Did the Fed do anything to try to get banks to increase their capital?

Levine goes on to talk about the Brooksley Born fiasco where Greenspan, Rubin, Summer and the SEC put the kibosh on Born's attempt to bring some transparency to the derivatives market.

Back to the SEC. In 2004 they made it easier for the five largest investment banks to gamble; the SEC ruled that these banks were exempt from the net capital rule and, thus, were able to take more risks. Then, the SEC allowed the banks to use their own risk assessment models. Levine really slams Christopher Cox, the previous head of the SEC. Cox eliminated the risk management office, and did not inspect any investment banks in the 18 months before Armageddon. Why should Cox have bothered? The banks were only handling $4 trillion in assets.

Fannie Mae and Freddie Mac - and ultimately Congress - are also blasted for their lack of control.

Levine has certainly done a fine job in making his points.

McClatchy Reports on the Credit Agencies Hearing

It's a pretty strong example of greed overcoming obligations to the financial community.

My emphases.

WASHINGTON — The chairman and chief executive of Moody's Corp. said Friday that he didn't know that his company continued to give investment-grade ratings to complex financial instruments backed by shaky subprime mortgages even after it downgraded billions of dollars worth of such deals in the summer of 2007.

His admission came during a daylong hearing by the Senate Permanent Subcommittee on Investigations, which is looking into the origins of the nation's worst financial crisis since the Great Depression.

Moody's chief Ray McDaniel, under questioning, said that he didn't think his company had continued to rate complex deals backed by U.S. mortgages after it and competitor Standard & Poor's jolted the markets in July 2007 with massive downgrades of earlier deals.

"I apologize, I do not recall that," McDaniel said.

The panel's chairman, Sen. Carl Levin, D-Mich., then presented him with documentation that both Moody's and S&P gave investment-grade ratings to a Citigroup deal in December 2007, worth almost $400 million, backed by shaky subprime loans that by then clearly were toxic.

The point Levin was making — and made repeatedly — is that credit-rating agencies did whatever was needed to get lucrative fees, some as high as $1.4 million, for rating complex deals.

Later, McDaniel stressed that preserving market share "is not as important as ratings quality."

While other Wall Street executives have expressed contrition when they appeared before Congress, McDaniel and former S&P President Kathleen Corbet were unapologetic on Friday.

Throughout the day in earlier testimony and in e-mails released by Levin, however, former Moody's and S&P officials told how they were pushed out or quit in frustration because managers badgered them to "massage" complex deals until they could land the business.

A McClatchy investigation in October documented how top managers from the structured finance division, which rated the complex deals, were moved into the top executive suites at Moody's and effectively took over the company.

McDaniel and Corbet said they were unaware that their analysts felt pressured to sacrifice the quality of investment-grade ratings to maintain market share and earn the huge accompanying fees.

Investment-grade ratings gave investors the illusion of safe bets, allowing big Wall Street firms such as Goldman Sachs to peddle the securities across the globe. Moody's and its chief competitors were key players in the prelude to a near meltdown of global finance in September 2008.

Called to appear before the panel, Richard Michalek, a former Moody's vice president and senior credit officer, described the ratings process for deals that could bring more than $1 million in fees as a "must say yes" atmosphere.

Frank Raiter, a former managing director at S&P and the head of the group that rated pools of residential mortgages, told the panel that analysts routinely sought direction from top management about the shaky deals they were being asked to rate.

"The guidance was not forthcoming from the top," he said, later adding, "I retired because I got tired of the frustration."

Levin read e-mail after e-mail from inside the ratings agencies about deals that never should have been rated, much less received investment-grade ratings.

"These e-mails are just devastating to the kind of culture that is going on here," he said.

Most striking was testimony from Eric Kolchinsky, a Moody's managing director who in 2007 was in charge of the division that rated the complex deals called collateralized debt obligations. CDOs are securities backed by pools of U.S. mortgages that have been packaged together into bonds and sold to investors.

Kolchinsky recounted how in the first two quarters of 2007, his group generated more than $200 million in revenue for Moody's by giving complex deals investment-grade ratings _ which told investors that they were safe bets. In the late summer of 2007, however, Kolchinsky was informed by superiors that bonds issued a year earlier were about to be severely downgraded.

That should have required a new methodology for ratings on deals that were still pending, but when he tried to do that, he was told not to. It amounted to securities fraud, in his opinion.

"My manager declined to do anything about the potential fraud, so I raised the issue to a more senior manager," he testified. He said that the complaint resulted in a change to methodology. "I believe this action saved Moody's from committing securities fraud. Because of the culture, I knew what I did would possibly jeopardize my role at Moody's."

He was right. A month later, he was sent a nasty e-mail asking why his market share slipped from 98 percent to 94 percent in the third quarter. The e-mail came, he said, just days after Moody's had downgraded more than $33 billion in bonds backed by subprime mortgage loans. Less than two months after challenging the integrity of the ratings, Kolchinsky was removed from his post and given a lower-paying job elsewhere in the company with far less responsibility. He eventually left.

Under questioning from Levin, Kolchinsky acknowledged that he and his staff rated the complex Goldman Sachs deal that this month became the subject of fraud charges brought against Goldman by the Securities and Exchange Commission.

The SEC alleges that Goldman failed to disclose to investors that hedge fund mogul John Paulson helped pick the mortgages in the deal with an eye toward betting that they'd fail. Kolchinsky said this information was never shared with Moody's.

"I did not know and … I am fairly certain my staff did not know either," Kolchinsky said.

Asked by Levin whether that would have affected the rating the deal received, Kolchinsky said yes.

"From my perspective it is something I would have wanted to know. It is more of a qualitative, not quantitative assessment. It changes the incentives of the structure," Kolchinsky said. "It just changes the whole dynamic of the structure."

In one e-mail presented by Levin, an S&P employee inquiring about evidence that subprime lender Fremont General was showing problems with poor underwriting was told not to worry about it. Levin seized on this e-mail when grilling Susan Barnes, an S&P managing director, angrily asking her why relevant information and poor performance was discarded.

"Why doesn't the supervisor say, 'Damn right, it's relevant,'?" demanded Levin, eventually coaxing a response from Barnes.

Barnes said that, "The assumptions we use in our criteria have obviously not panned out the way we had expected."

In written remarks, Corbet gave no ground. She said all deals were rated by teams of analysts, who were supervised by individual managers. Her role as president, Corbet said, was to set overall strategy and work with her parent company, McGraw-Hill.

McDaniel also offered no apology. Instead, he said that his company took steps to remedy what was going wrong as information became available. Former Moody's executives testified to the contrary.

McDaniel said that Moody's warned of declining underwriting standards for mortgages as early as 2003. However, Moody's continued to rate the complex deals backed by U.S. mortgages, which became a huge portion of the company's business.

Moody's is under pressure on many fronts. California Attorney General Jerry Brown this week filed a court action seeking to force Moody's to comply with a subpoena he issued for information seven months ago. A special Financial Crisis Inquiry Commission, charged by Congress to report on the causes of the crisis, issued a subpoena to Moody's, complaining that the company has failed to provide information in a timely manner.

Where we are now

Jeff Madrick has a really good summary in the NY Review of Books of where the economy is in April 2010:

A year and a half after the bankruptcy of Lehman Brothers and the near collapse of the global financial system that followed, the US Congress still has adopted no new rules to reregulate financial institutions. Well over three years have passed since the housing market began to unravel after an unprecedented boom fed by Wall Street speculation. Some financial firms borrowed more than forty times their capital at the height of speculation in 2006 and 2007 to invest in mortgage and other securities. Yet today, there are still no significantly higher capital requirements for them. There are no restraints on multimillion-dollar banker compensation, except on the executives of companies that took and have not yet paid back bailout funds from the Bush administration’s $700 billion Troubled Asset Relief Program (TARP). Most of the major firms, including Goldman Sachs and even struggling Citigroup, already have.

There are no adequate new restrictions on the private credit-rating agencies such as Moody’s, which doled out AAA ratings in increasing numbers even as mortgage securities became far more risky in 2006 and mortgage defaults started to rise. There are no new requirements to trade derivatives openly and transparently, and they are still being traded in obscurity. The value of these highly leveraged and typically volatile instruments was based on other more stable securities, such as treasury bonds, which enabled investment firms to take on more risky investments while avoiding regulatory restrictions. And there are no new regulations to protect consumers from credit card or mortgage fraud, despite rampant deception and abuse of homeowners.

Meantime, financial institutions are thriving again. After many posted large losses in 2008, the banking firms earned record profits in 2009, and are set to pay as much as $145 billion in bonuses to their employees. The rest of the American economy is largely suffering. A congressional oversight panel headed by Harvard Law School professor Elizabeth Warren reported in December that lending to businesses and consumers by major banks was down from the previous year, especially by the twenty banks that received the biggest bailouts. The unemployment rate hovers around 10 percent. When those who have given up looking for jobs or are taking temporary jobs are included, about one in six Americans who want to work full-time cannot do so. Household incomes are suffering in general and because of high levels of debt, few experts see a strong economic recovery in the making. Three years after housing prices fell by an average of one third, they are still not rising. As a result of the recession the federal deficit keeps increasing as tax receipts flounder, preventing the federal government from introducing programs to rebuild infrastructure, improve education, and provide health care for all Americans.

The Devil Is In The Details

Who knows what Dodd's proposed financial control bill really says but the fact sheet he put out isn't bad. Here's the summary:

Consumer Protections with Authority and Independence: Creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices.

Ends Too Big to Fail: Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

Advanced Warning System: Creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy.

Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.

Federal Bank Supervision: Streamlines bank supervision to create clarity and accountability. Protects the dual banking system that supports community banks.

Executive Compensation and Corporate Governance: Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation.

Protects Investors: Provides tough new rules for transparency and accountability for credit rating agencies to protect investors and businesses.

Enforces Regulations on the Books: Strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest and manipulation of the system that benefit special interests at the expense of American families and businesses.

It may sound cruel but this bill is really more important than the health bill, but it's been relegated to the shadows by the health bill. Will our leaders pass it or any bill which limits the power of the financial industry?

Correcting the Credit Rating Agency Problem

Kevin Hall continues his reports on the credit rating agencies with an analysis of the Accountability and Transparency in Rating Agencies Act, which is being proposed for approval by the House Financial Services Committee. This analysis is not as deep as Hall's previous work. He cites three deficiencies with the p

Image by Getty Images via Daylife

roposed legislation:

• there is no independent due diligence with regard to a proposed offering
• the position of compliance officer needs to be strengthened considerably
• the SEC should work with the compliance officer.

My question is - does the legislation ensure that the agencies do their job or does it enable them to continue their pursuit of money?

Regulating a Key Player

Bloomberg points out that hardly any of the talk about financial regulations mentions the rating agencies, yet they are a key player in the game. As the TARP IG said in his latest report, “The wholesale failure of the credit rating agencies to rate adequately such securities is at the heart of the securitization market collapse, if not the primary cause of the current credit crisis.”

Is there a need for them? If so, we need to devise a better system to rate securities.

The IG Does Not Seem Enthusiastic

Neil Barofsky, the Inspector General for the TARP, has issued his latest report. He does not give the Treasury an "A". It's doubtful that he'd even give a gentlemanly "C".

His first concern is with information, like how is our money being spent. The Treasury does not seem overly interested in the issue. Barofsky thinks that the risk of fraud with regard to the TALF and PPIF is fairly high. The Treasury's reliance on the credit agencies is particularly egregious as “The wholesale failure of the credit rating agencies to rate adequately such securities is at the heart of the securitization market collapse, if not the primary cause of the current credit crisis.”

From the horse's mouth

In late November 2007 Fitch Ratings issued a report entitled "The Impact of Poor
Underwriting Practices and Fraud in Subprime RMBS Performance". Here is an excerpt from the report summary:

In order to better understand the nature and impact of poor underwriting and fraud on subprime RMBS performance, Fitch analyzed a targeted sample of early defaults from 2006 Fitch-rated subprime RMBS. Fitch’s findings from this review include:
• Apparent fraud in the form of “occupancy misrepresentation.” The borrower’s stated intent was to occupy the property, but there is evidence in the loan files that this did not occur, and that it is likely that occupancy was never the true intent of the borrower.
• Poor or lack of underwriting relating to suspicious items on credit reports. The loan files of borrowers with very high FICO scores showed little evidence of a sound credit history but rather the borrowers appeared as “authorized” users of someone else’s credit.
• Incorrect calculation of debt-to-income ratios.
• Poor underwriting of “stated” income loans for reasonability of the indicated income.
• Substantial numbers of first-time homebuyers with questionable credit/income.
• In one instance, acknowledgement by the borrower of being the “straw buyer” in a property flipping scheme.

What the report does not say is how many of these loans received Fitch's top rating.

And to top it off

It's obvious that AIG does not give one fig about our money. I learned today that they paid the credit default swap claims in full even though the claims stemmed not from a default on the insured securities but because AIG's credit rating was lowered.

One would think that if it were your money, you would try to negotiate a lower payment as the underlying security is still good. Apparently, AIG did not consider that as it was our money, not theirs. I wonder how much influence can be attributed to the fact that one of the parties paid in full was Goldman Sachs, Paulson's former firm.

Geithner should resign and we should sue AIG. It is true - truth is stranger than fiction.

Internal Control, Valuation, Strategy

The Inspector General for the TARP has published his first report. Would you have guessed that the management of the program does not get an "A"? The biggest concerns are listed in my title above.

There really are few controls to ensure that our money is being spent and spent wisely. As for strategy, there is no portfolio management at all (how long should we hold these securities, what should the selling price be). Valuation of those securities purchased thus far seems to be out of whack as it looks like we got $78 billion less than we thought we had bought.

The valuation issue affects not only the past. The Fed will be spending another $600 billion buying up student loans, car loans and credit card debt. Who will value these securities? The same rating agencies who valued the CDOs.

If you don't want to read the 189 page report, read this.

Too Much Data, Little Information

Among all the various issues to be addressed in trying to dig out of the current crisis, Mark Thoma argues for the importance of information you can trust. And trust in information - whether from a credit rating agency or a CPA's audit - is in short supply today. He argues "even if we recapitalise every bank that is in trouble, remove every existing toxic asset on every bank balance sheet, and refinance every mortgage so that it is not in danger of default, we still will not have fully repaired financial markets. We will still be left with a lack of trust—for good reason—in the informational architecture people use to make financial decisions." He has a point.

His solution is "to provide insurance against the risks caused by the lack of information during the time period when the information flows are being restored". Whether its government or private insurance is immaterial to him. The important issue is to restore trust.

System Failure

In Vanity Fair, of all places, Joe Stiglitz diagnoses the system failure that he feels led to the current economic crisis.

• The system started to go haywire more than twenty years ago when Reagan replaced Volcker as head of the Fed with Greenspan; this ushered in the decline of regulation.
• Deregulation was codified in 1999 with the repeal of Glass-Steagall, which had built a wall between commercial and investment banking.
• Next was an SEC decision in 2004 to bump the debt-to-capital ratio of investment banks from 12:1 to 30:1.
• Then we had a failure of the accounting profession and credit rating firms to do their jobs properly.
• And the October bailout added to the problem because it did not address the fundamental causes.

While there have been several decision points that went awry, Stiglitz feels that the basic problem was an inordinate belief in the power of the market to self-adjust and a disbelief that government intervention is ever necessary.