Why Uncle Sam should also be suing himself, not just S&P

The US government has filed a lawsuit against rating agency Standard And Poors (S&P) seeking $5 billion in damages. The suit, filed by the Department of Justice, alleges that the rating agency gave good ratings to bad mortgage securities to earn a handsome income.

In the United States a home loan is referred to as a mortgage.

Let’s try and understand this in a little more detail. Starting somewhere around 2002, American banks and other financial firms started giving out what came to be known as sub-prime home loans. The term ‘prime’ was used in reference to the best customers of the bank. And loans to such customers were prime loans.

In its strictest sense, a sub-prime loan was defined as a loan given to an individual with a credit score below 620, who had no assets and was thus unlikely to qualify for a traditional home loan. A credit score was a number calculated on the basis of the borrower’s past record at paying bills and loans of all kinds, the length of his credit history, the kind of loans taken, etc.

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On the basis of the number the lender could get some sort of an idea on what sort of a risk he would enter into by lending to the sub-prime borrower. That was the purported idea behind the credit score. In the normal scheme of things, a borrower categorised as “sub-prime” would not have got a loan.

[caption id=“attachment_616904” align=“alignleft” width=“380”] American government (through SEC) should be blamed for persisting with a regulation which allowed issuers of bonds, i.e. banks and other financial firms, to shop for a rating.[/caption]

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But those were days when anybody and everyone got a loan. Banks did not keep sub-prime loans on their books. They bundled these loans together and sold bonds against them. The interest paid on these bonds was lower than the interest the bank was charging on the home loan. The difference in interest was the money made by the bank. This process was referred to as securitisation.

The bonds were bought by investors of various kinds. When the borrowers of home loans paid interest on their loans that interest was pooled together and used to pay interest to those investors who had bought these bonds. The same thing happened with the principal on the home loan that was repaid by the borrowers. It was pooled together and used to pay off the investors who had bought these bonds.

By “securitisating” loans, banks could pass on the risk of the home loan defaulting on its books. Also, by securitising sub-prime home loans, banks got back the money they had lent out as home loans immediately. This allowed them to give out fresh sub-prime home loans which they again securitised by issuing bonds and so the system worked. The bank also charged a fee from investors for securitising bonds.

If a bank had kept the loan on its books for the entire duration of the home loan, as used to be the case earlier, they wouldn’t have been able to make fresh loans immediately. Also, they would have to carry the risk of default by borrowers on the home loan on their books.

As far as investors were concerned, they got to invest in a financial security which gave a better rate of return than government and most corporate bonds. But what made them really invest in sub-prime bonds was the fact that they got very good ratings from rating agencies like S&P, Moody’s and Fitch. So here was a financial security which had a rating which was as good as the government bond or a corporate bond, but gave a higher rate of return.

What was ironical was that the sub-prime home loan bonds were given the best rating of AAA. Sub-prime loans were basically being given to people who would have not got loans in the normal scheme of things. The lending terms had become so easy that home loans could be made to someone with No Income, No Jobs, or Assets for that matter (or NINJA loans for short).

The lenders also introduced a loan where the borrower could simply get a loan by stating his or her income. The lenders wouldn’t make any effort to verify it. These loans came to be referred to as liar loans. In 2006, 40 percent of all sub-prime loans were liar loans.

Given this, the risk of default on sub-prime home loans was very, very high. And loans with a very high chance of default couldn’t be rated AAA, which is what was happening.

But why were the rating agencies rating sub-prime bonds which were backed by sub-prime loans most likely to be defaulted on handing out AAA ratings? For this we have to go back in history.

In fact, a major reason why sub-prime bonds were able to get the AAA rating - the same as the government or blue chip corporates - was because of something that happened way back in 1970. This was the year when Penn Central, the biggest railway company (or what Americans call a railroad) in the United States, went bankrupt due to sustained losses in its passenger as well as freight operations. This was an event that credit rating agencies were not able to foresee.

Till this point of time the rating agencies ran a subscription-based service. Hence what the rating agency thought about a particular new bond was not known to the world at large but only to those who had the subscription service of the rating agency.

In response to the crisis, the Securities and Exchange Commission (SEC) mandated that brokers holding onto bonds which were less than investment grade would be penalised. But this immediately raised the question on who would decide what ‘investment-grade’ was? So SEC created a new category of officially-designated rating agencies. The rating firms Standards & Poor, Moody’s and Fitch were designated to be the three officially-designated rating agencies.

What the SEC was effectively saying was this: what the rating agencies thought about a bond was too important to be restricted only to those who were willing to pay for their subscription service. Hence, every rating from then on was publicly available.

But the ratings agency was a business at the end of the day, they had to also make money. The question was who would pay them if their ratings were publicly available? So the SEC deemed that the company which was in the process of issuing a bond should get itself rated from the rating agencies and pay them for it as well.

This created a clear conflict of interest. The rating agencies could be easily played off against one another. And this is what happened during the entire sub-prime boom.

Banks and other financial institutions looking to rate their sub-prime bonds played off one rating agency against the other. If they did not get the AAA rating they were looking for their bonds they threatened to take their business elsewhere.

What did not help was the fact that the money the rating agencies made on rating sub-prime bonds was three times the money they made on rating other standard corporate bonds. This resulted in a lot of sub-prime bonds being rated AAA.

While the bonds may have been rated AAA, the basic point was forgotten. No bonds could be better than the home loans that were outstanding against them. And the fact of the matter was that the sub-prime home loans were the worst of the lot.

Given this, it doesn’t make any sense on part of the American government to blame only S&P for what happened. The other two officially designated rating agencies Moody’s and Fitch are equally to be blamed. And so is the American government (through SEC) for persisting with a regulation which allowed issuers of bonds, i.e. banks and other financial firms, to shop for a rating.

Vivek Kaul is a writer. He can be reached at vivek.kaul@gmail.com