We know what you're thinking: Why isn't anyone in jail? By the summer of last year, it was clear that the subprime housing market was a catastrophe. Junk mortgages had been offered to janitors or day-care-center operators, and financial institutions had sold the debt to funds. Much of it was garbage. But we thought otherwise"”because the credit-rating agencies told us so. Time after time, Fitch, Moody's, and S&P were asked to evaluate securitized mortgage tranches, on behalf of the very issuers who pay their fees. Time after time, they blessed them with a AAA rating.
White-collar fraud convictions are notoriously hard, as the recent Bear Stearns (BSC) acquittals showed. But why aren't the feds even trying to pursue a criminal investigation of the Big Three?
Because the federal government has almost no power to do so. The credit-rating agencies lie at the heart of our financial markets, but Congress has banned the Securities and Exchange Commission from fining or prosecuting anyone who defrauds investors. Historically, the agencies have even been protected from civil lawsuits, no matter what they do. This may change in the next few weeks, as Congress considers giving the SEC broad new powers. And recently, a federal judge broke with years of precedent and allowed an investors' lawsuit against Moody's to move forward. But on the whole, the agencies have been remarkably shielded from legal consequences.
Consider this: Last year, the SEC released a damning report on the agencies' role in the subprime crash. It even had a smoking gun that revealed analysts knew some securities were junk. In an internal communication, SEC investigators discovered that, "One analyst expressed concern that her firm's model did not capture "?half' of the deal's risk, but that "?it could be structured by cows and we would rate it.' " The SEC had the power to conduct this investigation thanks to the Credit Rating Agency Reform Act of 2006. But the same law denied the SEC any authority to punish the agencies for fraud. All the SEC can do is tell them not to do it again.
In fact, drafters of the 2006 law went out of their way to state that it "creates no private right of action." In other words, you can't even use this law to sue them. As a result, whenever anyone has filed a lawsuit against the agencies, the courts have thrown them out, citing the First Amendment. In the absence of any explicit provision exposing the Big Three to civil liability, the courts have accepted their defense that they're just citizens of the Republic, exercising their right to free speech.
The federal government may be neutered when it comes to going after the credit-rating agencies, but the state attorneys general have been surprisingly slow to step up. More than two years have passed since the collapse of the subprime market, and rating agencies are only now beginning to feel some heat.
So far, two states have taken a serious stab at chasing the Big Three. New York state Attorney General Andrew Cuomo launched an investigation when the bubble popped in 2007. But after a year, he killed the probe and cut a deal with the agencies that let them off the hook. Under the terms of their agreement, the Big Three agreed to a cosmetic adjustment in how they get paid, and the AG backed off. From now on, the rating agencies will collect a fee from financial institutions for agreeing to examine a bond issue, rather than formally rating one. This deal did nothing to address the fundamental conflict of interest at the heart of the system. But at least Cuomo got to issue a press release.
California Attorney General Jerry Brown may be a bit more serious. In September, his office launched an investigation into whether the agencies' role in the subprime housing collapse violated any state laws. Brown has subpoenaed the Big Three, ordering them to provide information that will determine if they gave high ratings to securities they knew were undeserving, fraudulently inflated the quality and independence of the ratings, or "conspired with the companies whose products they rated to the detriment of investors," according to a press release from Brown's office. To be sure, Brown's got his work cut out for him. Simply demanding that the agencies turn over relevant information won't do it. You need months, if not years, of internal communications"”and then you have to read them all, looking for evidence of conscious fraud. Scott Gerber, a spokesman for Attorney General Brown, refused to specify whether the subpoenas demanded this sort of detail. But Brown's office has a lot of lawyers, and in California, we may finally have an attorney general with the resources to find out why these companies so systematically misled millions of investors. Along the way, Brown might even shame Congress into ending impunity for the agencies.
Not that these congressmen need much more prodding. They know they let the agencies off the hook in 2006, and many House Democrats are working to make the Big Three feel the sting of regulation. On Oct. 27, the House Financial Services Committee approved a bill by Rep. Paul Kanjorski that would add new restrictions on credit rating agencies and expand the SEC's authority. Under the bill, agencies would be forced to add at least two outsiders to its board of directors, with the hope that they would mitigate the most egregious conflicts of interest that occur when the people asking for your judgment pay your salary. Most importantly, the bill gives investors the power to sue the agencies, ending decades of legal immunity.
The bill is expected to reach the House floor sometime in November, and the Senate will get a crack at it after that. A separate bill will double the SEC's budget over the next five years. So in some ways, at least, the party's over for the Big Three.
But one element never made it out of committee. Once again, Congress passed on the opportunity to add criminal penalties against the rating agencies. If the Big Three defraud investors on a historic scale, lie to millions of people about the creditworthiness of junk mortgage tranches, and cash their checks while another market collapses, they might someday pay a little money in civil court. But no one will ever go to prison. As rackets go, that ain't bad.
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