Normative Narratives


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Economic Outlook: Accountability and Oversight in the Financial Sector

In February I wrote a blog titled “Helping the Poor and Changing Our Standards, The DoJ vs. S & P“, and promised to keep my readers up to date on this important case. For those who do not wish to reread that whole post, here are the most pertinent details:

“The Justice Department plans to file civil fraud charges against the nation’s largest credit-ratings agency, Standard & Poor’s, accusing the firm of inflating the ratings of mortgage investments and setting them up for a crash when the financial crisis struck.”

“The Justice Department has decided to sue S & P for $5 billion. S & P contends it did no wrongdoing leading up to the housing crisis. The company will point to the facts that the Fed didn’t even know the severity of the housing bubble just days before it popped, and that its ratings were similar to those of other agencies.”

“The case is said to focus on about 30 collateralized debt obligations, or C.D.O.’s, an exotic type of security made up of bundles of mortgage bonds, which in turn were composed of individual home loans. According to S.& P., the mortgage securities were created in 2007, at the height of the housing boom. S.& P. was paid fees of about $13 million for rating them.”

Here’s the role the DoJ will argue S&P played in perpetuating the housing bubble:

“The three major ratings agencies are typically paid by the issuers of the securities they rate — in this case, the banks that had packaged the mortgage-backed securities and wanted to market them. The investors who would buy the securities were not involved in the process but depended on the rating agencies’ assessments.”

“In its complaint against S&P, the Justice Department accused S&P of defrauding Western Federal Corporate Credit Union, and other institutions that purchased certain securities based on the high ratings by S&P.

Some credit unions are required by law to rely on credit ratings issued by firms that included S&P in making its investment decisions, the complaint said.”

It is my pleasure to inform my readers that a judge has given this case the “green light“, a step towards holding S & P accountable for its role in the financial crisis:

“The U.S. government may proceed with its $5 billion lawsuit accusing Standard & Poor’s of misleading investors by inflating its credit ratings, after a federal judge rejected the rating agency’s effort to dismiss the civil fraud case

In a written decision late on Tuesday, the judge said the government could pursue claims that S&P manipulated ratings to boost profit, and in doing so, concealed credit risks and conflicts of interest.

This led to large losses for investors and contributed to the 2008 financial crisis, the government contended.

“The government’s complaint alleges, in detail, the ways in which none of S&P’s credit ratings represented the thing that they were supposed to represent, which was an objective assessment of creditworthiness, because business considerations infected the entire rating process,” wrote U.S. District Judge David Carter, in Santa Ana, California.”

“The lawsuit accused the largest U.S. credit rating agency of inflating ratings to win more fees from the issuers and bankers that pay for them.

It also said S&P failed to downgrade ratings for collateralized debt obligations despite knowing they were backed by deteriorating residential mortgage-backed securities.

According to the complaint, S&P rated more than $2.8 trillion of RMBS and nearly $1.2 trillion of CDOs from September 2004 to October 2007.”

“S&P argued that, since the issuer banks had access to the same information and models that S&P analysts did, they could not have been fooled by faulty credit ratings,” Carter wrote.

“This begs the question: If no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting that, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness?”

This is indeed welcome news, as I am sure once the case is underway more information will be brought to light. While I do not take a normative stance on credit agencies in general, the effects of large agencies (such as S & P) ratings on financial valuation cannot be overstated.

To the extent that the lawsuit will explore what role S & P played in perpetuating the financial crisis, and then hold S & P accountable for that role, the judges decision is one that benefits society as a whole by overcoming the power-asymmetry / collective action problem(s) individuals face in holding large institutions to account. Since that is essentially what Normative Narratives is all about, I am happy that the judge will let this case go forward. Of course the wheels of justice move very slowly, so it could still be months / years until a final ruling is made/ appeals finish and any money is paid back, but this decision is a step in the right direction. Any money the U.S. government gets from this case should go towards helping people with refinance underwater mortgages; evidence suggests that low-income families were specifically targeted by lenders in the years leading up to the housing market collapse.

Part of learning from past mistakes is holding the actors who perpetuated / profited from them accountable. Another part of learning from past mistakes is putting safeguards in place to prevent them from occurring again. The former has been addressed on an ad-hoc basis (many would argue not enough has been been done, but lets not allow the unattainable pursuit of perfection get in the way of achievable progress). The later was partially addressed this week with the confirmation of Richard Cordray as the head of the Consumer Financial Protection Bureau:

“The Consumer Financial Protection Bureau was conceived by a Harvard professor, embraced by the Obama administration and pushed into law by Congressional Democrats determined to expand the federal government’s authority to protect borrowers from abusive lending practices”

” [Senator Elizabeth] Warren proposed the creation of a federal agency to protect consumers of financial products in a 2007 article, memorably arguing that the government put more effort into ensuring the safety of toaster ovens than the safety of mortgage loans. The idea resonated with Mr. Obama and his senior advisers, and it became a centerpiece of the administration’s proposal to overhaul financial regulation.”

“‘It is a truly historic day,’ Warren told reporters before the vote. ‘There’s no doubt that the consumer agency will survive beyond the crib. There is now no doubt that the American people will have a strong watchdog in Washington.’”

“…the agency has begun to assert authority over non-bank financial companies, including mortgage and payday lenders, but its actions have been shadowed by uncertainty about the legality of Mr. Cordray’s appointment.”

“‘Today’s action brings added certainty to the industries we oversee and reinforces our responsibility to stand on the side of consumers and see that they are treated fairly in the financial marketplace,’ Mr. Cordray said in a statement.”

It remains to be seen how effective an institution the Consumer Financial Protection Bureau will be. But given the optimism of high ranking officials and the efforts that went into preventing Mr. Cordray’s appointment, it is safe to assume this is big news in the realm of financial reform.

I leave you with words from a previous blog of mine on the subject of accountability, which I believe continues to ring truer and truer with each passing day.

Despite the political and economic cynics out there, who in their great “wisdom” will tell you nothing is happening to hold powerful interests accountable for their role in the financial crisis, we have learned lessons (albeit incredibly hard learned lessons) and are taking steps to ensure we do not repeat our past mistakes.


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Economic Outlook: Helping the Poor and Changing Our Standards, The DoJ vs. S & P

Say what you will, but you can’t say the Department of Justice isn’t going after the institutions responsible for perpetuating and deepening the housing crisis. First it went after the big banks (which recently settled for$ 8.5 billion), and now Standard & Poor’s (marking the first such case against a credit rating agency):

“The Justice Department plans to file civil fraud charges against the nation’s largest credit-ratings agency, Standard & Poor’s, accusing the firm of inflating the ratings of mortgage investments and setting them up for a crash when the financial crisis struck.”

The Justice Department has decided to sue S & P for $5 billion. S & P contends it did no wrongdoing leading up to the housing crisis. The company will point to the facts that the Fed didn’t even know the severity of the housing bubble just days before it popped, and that its ratings were similar to those of other agencies.

“The case is said to focus on about 30 collateralized debt obligations, or C.D.O.’s, an exotic type of security made up of bundles of mortgage bonds, which in turn were composed of individual home loans. According to S.& P., the mortgage securities were created in 2007, at the height of the housing boom. S.& P. was paid fees of about $13 million for rating them.

Prosecutors, according to the people briefed on the discussions, have uncovered troves of e-mails written by S.& P. employees, which the government considers damaging. Portions of those e-mails are likely to be disclosed in the government’s complaint, these people said. The firm gave the government more than 20 million pages of e-mails as part of its investigation, the people with knowledge of the process said.”

Here’s the role the DoJ will argue S&P played in perpetuating the housing bubble:

“The three major ratings agencies are typically paid by the issuers of the securities they rate — in this case, the banks that had packaged the mortgage-backed securities and wanted to market them. The investors who would buy the securities were not involved in the process but depended on the rating agencies’ assessments.”

The three major ratings agencies are S&P, Moody’s, and Fitch; at this point the suit is only set to be filed against S & P, although subsequent cases could implicate the other two agencies, especially if the DoJ is successful in proving wrongdoing between S & P and the financial institutions it rates.

Paul Krugman weighs in on why financial reform is still important: Financial reform and holding financial institutions responsible for past violations are not the same thing. But viewed together, they both represent taking America back from corporate interests and making the country work for the average U.S. citizen. It represents a Wall St. vs. Main St. fight that has been long overdue.

“How can the G.O.P. be so determined to make America safe for financial fraud, with the 2008 crisis still so fresh in our memory?…Right now, all the media focus is on the obvious hot issues — immigration, guns, the sequester, and so on. But let’s try not to let this one fall through the cracks: just four years after runaway bankers brought the world economy to its knees, Senate Republicans are using every means at their disposal, violating all the usual norms of politics in the process, in an attempt to give the bankers a chance to do it all over again.”

The Obama administration and the Justice Department seem to be thinking along the same lines as PK. Some may argue that more resources should be focused on holding responsible those individuals who were central in perpetuating the housing bubble. The issue with this goal is who to go after? Should it be the CEOs [who still received huge bonuses and salaries despite taxpayer bailouts]? Should it be the financial engineers who created derivatives that were too complex for most people to understand, or perhaps the bankers who made large commissions by knowingly selling mortgages to people who could not afford them?

By focusing on the organizations as a whole, and pursuing a civil case instead of a criminal case, the DoJ is giving itself the best opportunity to win the case. Sometimes we have to look past the narrow definition of what we feel would be “right” and instead focus on what is most feasible.  In these cases, a significant portion of the money won is supposed to go directly towards helping those whom were taken advantage of and lost their homes due to delinquent practices by financial institutions (who tend to be the poorest people who were seen as easy targets).    If the DoJ can prove wrongdoing by S & P and win this case, you can be sure that Moody’s and Fitch will be the next rating agencies in the hot seat.  Every dollar won back to help those who lost their homes due to illegitimate business practices by financial institutions is a dollar worth fighting for.

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