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.
Source:
Mary W. Walsh and Ron Nixon, “Case
Details Internal Tension at S. & P. Over Subprime Problems,” The New York Times, February 5, 2013.
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