In sending a message to S & P as well as Wall Street more generally regarding the excesses in the securitization of subprime mortgages that contributed materially to the financial crisis of 2008, the U.S. Government and several state governments announced in early 2013 that they would sue S & P for $5 billion as a penalty and to cover damages to state pension funds and federally-insured banks and credit unions. The operative assumption was that such a monetary figure would have considerable force as a disincentive to profit by means of fraud. Would $5 billion be sufficient for the message to be delivered not only S. & P. but also to Wall Street?
According to U.S. Attorney General Eric Holder, the action “marks an important step forward in the administration’s ongoing effort to investigate—and punish—the conduct that is believed to have [contributed] to the worst economic crisis in recent history.” According to the U.S. Justice department, the subprime mortgages underlying the derivative securities being rated by S & P were already falling at a high rate in the fall of 2006. Even though some employees at the agency saw this as a red flag, the firm’s policy was to maintain market share rather than lower the high ratings. Simply stated, there was more money in it for S & P with the higher ratings. According to an internal message by one S & P employee in the spring of 2007, “We rate every deal. It could be structured by cows and we would rate it.” The motivation is to maintain market share in the ratings business. Additionally, the rating agency gets a cut every time one of the securities it rates is sold. Because a higher rating will induce more sales, the agency has a financial incentive to rate securities too high.
The $5 billion being sought by the government is more than S. & P. made in 2011. Admittedly, this seems like a strong financial disincentive for rating agencies to commit such fraud again. However, the time value of money alone tells us that the gravity of immediate profit is more than that of even a probably civil penalty. Furthermore, if the bonuses paid out when the profits were rolling in from the subprime-based derivatives are not “clawed back,” it would still be in the financial interest of managers at the rating agencies to overstate the ratings, particularly if the executives have the ability and intent to jump ship in the meantime. “This market is a wildly spinning top which is going to end badly,” one executive at S. & P. wrote in a confidential memo before the financial crisis hit. The obvious play at least for that executive would be to reap the bonuses for as long as possible before getting off the merry-go-round before there’s hell to pay. Let the firm pay the damages, such an executive (and doubtless many others as well) would reason.
In being an established institution, S. & P. can make use of the benefit of the doubt. latimes.com
Beyond providing the after-the-fact financial disincentive to counter the tremendous profits made in rating the derivative securities too high, admitting to the wrong-doing could be of value. In particular, not being able to count on simply paying civil damages and penalties without having to admit guilt could dissuade rating agencies from overstating ratings for immediate profits in the future. The reason is that reputation is known to be related to long term profitability. Additionally, the admission of guilt, whether voluntarily or in a verdict, would make the underlying institutional conflict of interest more transparent societally.
The face value of an institution’s denial can have considerable credibility societally. Consider the disavowal of S. & P.: “Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. S.&P. has always been committed to serving the interests of investors and all market participants by providing independent opinions on creditworthiness based on available information. Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. S.&P. has always been committed to serving the interests of investors and all market participants by providing independent opinions on creditworthiness based on available information.” There is no mention of the countervailing financial incentive to the rating agency wherein it stands to gain more revenue and market share from the increased sales of a security rated even too high. Prime facie, a business is oriented to making money. Asseverations not in line with it are mere public relations meant to retain a viable reputation in line with making still more money.
Denial as to institutional conflicts of interest begins with naivety on the role of financial inducements in business. Were S. & P. declared guilty in a verdict or to voluntarily admit guilt, the denial would take a hit because the hegemony of the immediate financial interest to the firm would be confirmed publically to be at the expense of the firm’s stated mission to investors and the public. It is indeed all too easy for people to take the rating agency’s claim that it is oriented to the “investor-interest” at face value, as if the agency’s own source of revenue were a mere afterthought. One key to beginning to make such a conflict of interest transparent is for the offending companies to admit wrong-doing or be found guilty.
Fortunately, the U.S. Justice department insisted during settlement talks that S & P admit to wrong doing in at least one of the counts of fraud. That this demand was in part behind the break down in settlement talks suggests how important public denial is to a company and how vital it is to the rest of us that the pattern of being able to obviate admitting any wrong-doing be broken. Indeed, the wrong-doing should ideally be tied not only to S. & P., but also to particular managers who were involved in the fraud. Regarding them, criminal prosecution would be an effective deterrent.
In short, a multi-pronged approach could be used by the U.S. Department of Justice (as well as departments of various state governments) in making sure that managers that exploit institutional conflicts of interest have a countervailing disincentive, financial and otherwise. Moreover, public policy is needed to decouple the conflicting roles in institutional conflicts of interest. Beyond creating disincentives, the problematic roles, such as in making money off rating securities and serving investors, can be severed not only in the case of rating agencies, but for public accounting firms as well. We as a society need not tolerate such conflicts of interest. The immediate challenge is simply in making them transparent. For scholars, the question to ponder may be why we as a society are so blind to them, whereas we immediately go after individuals who are exploiting a personal conflict of interest (e.g., bribery). Are we so in love with institutions that we look the other way when they are at the nexus of a conflict of interest? At the very least, we are selective enablers.
Mary W. Walsh and Ron Nixon, “Case Details Internal Tension at S. & P. Over Subprime Problems,” The New York Times, February 5, 2013.