DOJ v. S&P: The Feds Take On the Rightfielders of Finance

His trade is legendary now, so much so that the Wall Street Journal's Gregory Zuckerman penned a book about it titled The Greatest Trade Ever, but at one time John Paulson was something of a joke. Bulge bracket banks like Goldman Sachs took his calls and filled his orders in which he bought insurance on mortgage backed bonds, but in the eyes of his GS coverage (as recounted by Michael Lewis in The Big Short) Paulson was a "third-rate hedge fund guy who didn't know what he was talking about."

Of course one man's trash is another man's treasure, and Paulson saw an ugly future for mortgages that the broad marketplace did not. Paulson made $15 billion betting against mortgages not because his views were the consensus, but because he was once again a joke or, in the words of his Morgan Stanley coverage, "This guy [Paulson] is nuts." Had the markets not viewed Paulson as nuts, it's quite simply the case that he wouldn't have been able to make so much money on his trades meant to profit from troubles in the mortgage market.

Paulson's big and successful short of once highly demanded mortgage securities naturally springs to mind in light of the Department of Justice's recently filed lawsuit against Standard & Poor's. The charges that allegedly support this pathetic and all-too-predictable money grab are that S&P's ratings arm "ignored its own standards to rate mortgage bonds that imploded in the financial crisis and cost investors billions."

Where does one begin?

Probably the best place to start is to return to Paulson's aforementioned trade. Once again, the reason he was able to make so much money on his bet against mortgages was because the broadly held view in a very deep market was that the only direction for mortgage bonds was up. Because it was the prevailing view among some of the brightest and most savvy financial minds on earth, Paulson was able to buy insurance on those same bonds extraordinarily cheaply.

Looked at in light of S&P's alleged failure to properly rate mortgage bonds, it's worthwhile to return to Lewis's The Big Short. In it Lewis quotes accountant - and mortgage skeptic - Vincent Daniel this way:

"You know how when you walk into a post office you realize there is such a difference between a government employee and other people. The ratings agency people were all like government employees."

Ok, so some of the most prominent financial minds in the world were gulled by the stratospheric mortgage market, but the feds are suing the private sector's version of government employees for failing to see what the world's greatest investors could not? You can't make this up. But if readers are still scratching their heads, if the sharp minds of the investment world couldn't see a correction coming there was simply no way the mediocrities who walk the halls of Standard & Poor's were going to.

It's said that the DOJ's lawsuit against S&P will be long and costly, and if so, perhaps the functionaries at S&P should be flattered. Indeed, in filing the lawsuit against the much aligned securities rater, the federal government is ascribing skills to the individuals inside S&P that are otherworldly, and that would have them earning billions on Wall Street if they could actually get real Wall Street jobs.

An editorial in the Wall Street Journal approached the news about S&P from a somewhat different angle. Properly skeptical of the lawsuit itself, its editorial observed that "...investors who relied on the opinions of S&P and other big credit-rating agencies, Moody's and Fitch, suffered terrible losses during the crisis. That was in part because the federal government forced investors to rely on them." Not really. About the investors who suffered terrible losses relying on S&P et al, it serves them right if they actually took the analysis of the financial equivalent of the last player picked for a pickup basketball game seriously. Simple logic says they did not.   

As for the Journal's lament about the federal government essentially choosing the firms that it will allow to rate mortgages, this is much ado about nothing. While there certainly should be no federal barriers to any rater entering this space, it's surely fanciful to presume that the analysis would have been much better were it more open. If it's true that "those who can't, teach," then it's equally true that "those who can't work on Wall Street work as regulators or at ratings agencies." Simply put, a team of Little League right fielders is never going to have the skill to beat a team of Little League shortstops.

Despite this screamingly obvious mismatch of talent that made S&P's much-too-late discovery of troubles in the mortgage market inevitable, the $5 billion lawsuit against it continues. Call it payback for a downgrade as the Journal's editorial page has, but maybe a better word is shakedown. The feds basically handed S&P a monopoly, S&P failed very publicly in a way that embarrassed its patron in the federal government, so the lawsuit isn't for the failings of its raters (that they would fail with regularity is a tautology of the first order) as much as it is payment for maintenance of its ongoing near-monopoly role as paid rater of mortgage-backed bonds.

As for the big banks that have similarly been handed monopolistic powers for having been deemed "too big to fail," they should be uneasy for having been so crowned. Indeed, when they too eventually run into trouble yet again with their regulators inevitably late to discover their problems, they'll similarly be forced to pay the same federal government for their protection. Such is the sad life of the coddled few in a crony capitalist economic system.