Would the Hens Hire a Fox to Value their Eggs?

Let's say that you're in the business of rating products and services. Investors rely on your ratings to decide whether to buy a product, or whether to demand more return for greater risk. Now imagine that you're paid for this work by the companies whose products and services you rate. Can you say, "conflict of interest"? Sure you can.

Remember all those junk-quality mortgages that got split up and repackaged and sold as AAA-rated bonds? Sure you do.

That explains why, when Standard and Poor's downgraded US debt to AA+ (from AAA) status on Friday, I was less than impressed. As Paul Krugman wrote in today's New York Times, Standard & Poor's is "the last place anyone should turn for judgments about our nation’s prospects". (Full opinion piece, here)

S&P is, after all, the company that "gave Lehman Brothers, whose collapse triggered a global panic, an A rating right up to the month of its demise. And how did the rating agency react after this A-rated firm went bankrupt? By issuing a report denying that it had done anything wrong."

It didn't help S&P's case that the administration immediately pointed out a $2 trillion error in S&P's math. The rating firm argued briefly, conceded the error, and went ahead with the downgrade.

Just how good at their jobs are the rating agencies? In his Times "FiveThirtyEight" blog, Nate Silver calls S&P country ratings "substandard and porous", noting that, for example, their egregious $2 trillion error in the US downgrade came from "their lack of understanding of the way that bills are scored by the Congressional Budget Office". Not a way to engender trust in their acumen, wouldn't you say?

I'm not suggesting that we aren't facing serious financial and economic difficulties in this country; of course we are. But this blog isn't about economics -- it's about ethics.

I find it ethically troubling that S&P (and Moody's and Fitch) are primarily paid by the very companies whose products they are reviewing.

There isn't any question that a great deal of, um, questionable behavior was going on, at the banks, at the ratings agencies, and no doubt at the accounting and law firms that served the banks as well. Much of it is coming out in private suits. An article by Louise Story and Gretchen Morgenson in today's Times, for example, reports:

One case against Bear Stearns indicates that its employees put troubled mortgages into securitization trusts that it sold to customers, while simultaneously receiving reimbursement — known as apology payments — from the companies that originated the loans.

And a recent case against Morgan Stanley cited a witness saying that the bank would receive mortgages with documentation of a buyer’s income and then shred that documentation so that it could call it a “no doc” loan and pay less for it. Those banks dispute the accusations.

If these allegations are true, then I'm glad that lawsuits are uncovering it.

But can we pause for a moment here and wonder why the Justice Department hasn't gone after these firms? Or Moody's? Or, for that matter, Bank of America, which is likely to be sued by still-largely-taxpayer-owner AIG? (Story and Morgenson's article in the Times reports that AIG will claim that BoA "misrepresented the quality of the mortgages placed in securities and sold to investors.")

Perhaps AIG has the wrong target in mind for its suit. If they bought BoA mortgage bonds in part because they were AAA rated... maybe the rating agencies should be held accountable, too. The agencies would no doubt claim that BoA and its subsidiaries provided falsified data, and that they're just victims here too. I'm not buying it. What about you?