NYO: You’ve emphatically noted in the past intentional deception as what distinguishes being wrong from lying or from fraud. Much of the outrage directed at S&P when they downgraded American debt was: they failed to downgrade the CDOs and other toxic assets that assisted the 2008 crash, their credibility is shot, ergo, how dare they downgrade our debt. It’s pretty clear that—among the other reasons—they failed to downgrade these products because they’re paid to rate them by the people creating them. From a prosecutorial standpoint, is there an inherent deception in the system?
ELIOT SPITZER: Deception’s a strong word to use without actual proof of intent to deceive. When you look back at all the cases [the New York Attorney General's office] made, we actually had that proof. There were actual deceptive acts taken. I just want that as a backdrop.
NYO: But again, we’re talking about deception on a systemic scale.
ES: Right. There’s a structural flaw and has been forever in the way [ratings agencies] have been paid that’s led to a failure of hard analysis underlying many of their ratings. There should have been prosecutions in the past, there should’ve been a deeper analysis of those conflicts and the tensions that led to very poor analysis.
NYO: How would they’ve been prosecuted, though? It doesn’t seem like there’s an existing statute…
ES: Sure there is, the same way we brought the ratings case against the analysts. All you need is a common law fraud concept that people—and you go back to the emails, just as we did in the analyst case—and again, I’m not saying “let’s relive the past” This is a more theoretical matter. Go through the emails, and you would’ve seen—“this isn’t a triple-A, but they’re a good client, and we’re gonna…”—that tension between what ratings were put on a product, and one’s belief or recognition that they may not deserve it. There are many theories about what would be there, but you have to get the evidence, to state the obvious. I don’t want to say “gee, they should’ve been prosecuted.” But there should’ve been greater scrutiny over the years, and the structure has always been problematic. It was next on our hit parade, if I had been there for that.
NYO: Is there any way to effectively reform this system?
ES: The best answer—and I think the marketplace is moving to this—is to essentially tell the ratings agencies: “You’ve got to earn your credibility.” Let’s remove from them the position they had for many years, which was the government saying “You are designated as agencies to which we ascribe a certain elevated position. And you have been given this power by the government without having earned it.“ There’s no reason for that. And now I’m going to sound like a freemarketeer.
NYO: Haven’t they earned it, though? There are only ten ratings agencies certified by the government.
ES: They haven’t earned it based upon their performance.
NYO: …On the merit of their ratings.
ES: Right. In other words, when I say “earn it,” I mean “earn it” in terms of establishing to the marketplace that your ratings actually mean something.
NYO: Somehow, this hasn’t already happened.
ES: No. [There’s a] notion that there are no straight lines in the world, and what most people do—and understandably—is presume that lines continue in perpetuity. Rating agencies have been uniquely bad at spotting inflexion points, and that is, of course, what you’re paying them to do.
NYO: Not just that, but they’re being paid to be bad.
ES: Anybody can extend the line in the direction in which it has been moving. The hard part is saying “Wait a minute. There’s too much securitized mortgage debt out there, and therefore there’s a problem.” Quality control is lagging, and that’s what we’ve picked up by actually digging into the underlying mortgages.
NYO: That…is what the short-sellers picked up.
ES: That’s what the short-sellers picked up. That’s the sort of analysis the rating agencies should have done, if in fact they had been worth their mettle.
NYO: It’s not exactly a trenchant observation, but isn’t the inherent problem facing rating agencies as they stand that if one takes their bad products to a ratings agency, and they don’t rate it triple-A, you can just take it to the next guy? The free market!
ES: It’s why the rating agencies need to make a determination: either they will maintain their integrity, and they will be paid because people will value them in the marketplace, or you need to come up with a different payment mechanism. I’m not saying any of this is easy. “Who’s going to pay for honest research?” becomes a very difficult question.
NYO: Doesn’t honest research benefit these companies in the long-term?
ES: I’d think so. You need a payment mechanism to those who are going to do the real analysis that will not taint it or, if it’s tainted, let the marketplace know it.
NYO: What do you mean by ‘payment mechanism’? For the government to pay them?
ES: Well, look: I never wanted that. Remember, way, way back, we tried to come up with all the different permutations that were out there. We wanted to have independent research. And who’s gonna pay for it? There was a notion—and this caused a hullabaloo when it was floated; it wasn’t even my idea, but conceptually there’s nothing wrong with it—that the stock exchange would have research. The stock exchange as a not-for-profit would say: “Look, you guys go out there and do research” sort of as an academic exercise. But the question is, in this day and age, how can you derive a revenue stream from research whether you’re an analyst in the tech sector of a Morgan Stanley or you’re Fitch doing bond analysis. Because the information? Once it’s out there you can’t protect it very well. And if you put a negative rating, who’s going to pay for it? These are real problems. But what we do know is that as a consequence of this, the bond ratings—much like the analysts that we pursued—were uniformly and excessively positive.
NYO: The consequences of these excessively positive ratings have greater implications on the world beyond the private sector. You’ve said that “only government can take the steps necessary to overcome market failures.”
ES: Well, one type of intervention might just be: Take away all the government imprimatur that the rating agencies have and say ‘These guys are no better than what you have made of them in the past. They really haven’t spotted anything important. And you’ve got to do your own work.”
NYO: What was your reaction when you saw the S&P downgrade of American debt?
ES: I thought it was…interesting. It wasn’t an economic analysis.
NYO: It was a political analysis.
ES: It was a political analysis. The one thing we’ve thought there might be some modicum of skills retained by these companies was economic analysis. We haven’t ever viewed them as being political barometers. So now, in a way, they’re putting on an entirely different hat saying as a political matter, they’re downgrading our debt.
NYO: Are they out of their depth?
ES: I don’t think they are. But I don’t think they have any unique skills either. They’re smart people, and I think they reached the same conclusion that many folks have reached: our government has been somewhat—or greatly—dysfunctional dealing with macroeconomic issues, and that we’re kicking the can down the road both in terms of the deficit and in terms of what I view as the more important issue, job creation. But we don’t need S&P to tell us that. In other words: this wasn’t a very sophisticated analysis of debt exposure, where they picked up something we hadn’t seen about some pension obligation, and said “A-ha! Now we see where you’re hiding it. Hence: we’re downgrading you.”
NYO: What’s interesting about it, though, is that they actually did go out on a limb and distinguish themselves from the other agencies. And it feels like they’re being punished for it.
ES: They were not wrong in their political analysis. They’re wrong in their economic analysis. The risk of a default, having watched this exercise, is actually lower than it was in the past. In a sense, you could say that even with the Tea Party there, at the end of the day everybody said “We will not tolerate a default.” We know that. At that point I don’t think the downgrade makes sense, when you look at where we now stand in comparison to other government and private sector entities. Having said that, there was some criticism that this was sort of a finger back in the eye of government saying “Okay, you want to give us a tough time for missing the sub-prime debt? We’ll show you we still have some cards to play.” You know, look: I don’t want to challenge motive. Frankly, the market, to a great extent, has ignored their downgrade.
NYO: Funny how that nebulous “market” will take the ratings agencies’ stamps of approval when it wants them, but ignore them otherwise. Are they just totally useless right now?
ES: The rating agencies have provided a legal and emotional backstop for entities that have to make certain decisions and need to rely upon something. It’s somewhat akin to opinion letters in a takeover context. You need something that gives you the legal foundation to act. So if you’re a board of directors or an investment committee you can say “here’s our portfolio, and we’ve done our due diligence. Here are the rating agency’s statements.” You don’t really think that they’re worth that much. On the other hand, you also know that you don’t have the internal capacity to analyse the bonds out of some tiny sewer department that’s issuing the debt in the tiny county in some state out in the Midwest. To that extent, they provide some sort of baseline utility.
NYO: Allow us a moment of total, wide-eyed naivety: As someone who’s navigated the ridiculous thoroughfare of government bureaucracy, what are the odds that any legislator anywhere would take significant action on the systemic issue of ratings agencies?
ES: Probably slim.
NYO: Why? Because it seems like something that…
ES: Should have been done a long time ago? Or any prosecutor for that matter. I mean, there hasn’t been any meaningful effort to take a hard look at it.
NYO: It seems like now more than ever, this could be a win-win situation for somebody both in terms of political capital, and in terms of the climate required for one to actually succeed in that situation. And yet—again, this is knowingly naive—but nobody’s going through with it.
ES: It’s hard to finally close that loop. The institutional presence of the rating agencies—not to be excessively cynical…
NYO: It seems excessive cynicism is the realistic approach, here.
ES: Well, the status quo has its own momentum. Think how many localities and entities have received rating agencies work that have permitted them to access the markets. They receive the triple-A. They show up on Capitol Hill saying “Don’t take away this stamp of approval. We would never be able to get the teachers pension fund from Alabama to buy us, if we didn’t have this stamp of approval. So we need it.”
NYO: Enter lobbying dollars.
ES: Yeah, yeah. But it’s a shame. ‘Cause I think the reliance on the rating agencies was—as we all now know—one of the critical errors that permitted the bubble to inflate.
NYO: After the bubble inflated and popped, and after S&P recieves scrutiny over their sovereign debt rating, do you think, moving forward, that the mistakes made in the past could be repeated again with the ratings agencies?
ES: The mistakes inevitably will be repeated again.
NYO: Taking a different form.
ES: In a slightly different form. And it’s just a question of how long until it happens again.
NYO: Like Mark Twain says: “The past doesn’t repeat itself but…
ES: …it rhymes.” The best little book on this ever was Galbraith’s A Short History of Financial Euphoria. Galbraith gets it right. We keep doing it historically ‘cause debt and leverage are so addictive. As a narcotic, they get into our blood stream. We can’t get rid of them. So we’ve learned the lesson. The metaphor I used to use is that it’s like getting a speeding ticket. You learn the lesson for some period of time but then 20 miles down the road, 30 miles down the road, your foot starts going back down on the accelerator. It’s a question of for how long we’ve learned the lesson.
NYO: Is this something just inherent in human nature that can’t be controlled? On one hand, controlling it would really be sticking a deep hand in the free market, but on the other hand, if you leave it unattended to do this again, the only people we have to blame are ourselves.
ES: Which I think we know. The regulatory structure worked pretty well from the Depression until the mid-’80s, when we did have a slightly more aggressive approach to regulating leverage in those sectors that could cause enormous harm. Not without problems here and there. The answer is when we have some brake that can be applied to leverage and risk in that regard, we can do okay. When we take our foot off that brake, inevitably the bubbles re-emerge.
NYO: It seems like the foot’s coming off the break again. It’s only been two years.
ES: Well, let’s see what happens. It’s what makes life interesting, right? It’s what keeps a journalist in business. It’s what keeps prosecutors in business. ‘Makes it more fun.
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