Saturday, January 24, 2015

Standard & Poors: Internal Controls Enabling a Conflict of Interest

After the financial crisis of 2008, rating agencies reassured the public that additional “internal safeguards” would prevent the sort of over-stated ratings that had contributed to the crisis. Congress did not deconstruct the structural conflict of interest wherein a rating agency is tempted to overstate the rating on financial security such as a corporate bond because the agency’s revenue would be higher if more of the bonds are sold. I contend that reliance on a company’s internal “fire walls” is naïve, given the strong, sustained temptation that exists as long as an institutional or structural conflict of interest is in place. To obviate the problem, the conflict itself must be deconstructed.

In January 2015, the SEC announced that Standard & Poor’s “softened standards to win business and misled investors long after [the financial crisis].”[1] S&P agreed to a $77 million settlement with the SEC and the attorneys general of New York and Massachusetts without having to admit to any wrongdoing. The rating agency was still negotiating to pay more than $1.37 billion to more than a dozen other States and the U.S. Justice Department “to resolve claims that the firm misrepresented its ratings as independent and objective during the run up to the 2008 financial crisis.”[2]

Simply put, S&P’s improved safeguards were not sufficient to thwart the underlying conflict of interest. Incredibly, “a number of control weaknesses . . . went unchecked inside S&P even as the ratings industry reeled from accusations that it [had] issued inflated mortgage-bond grades during the last real-estate boom.”[3] Andrew Ceresney, the SEC’s enforcement director, said investors were “in the dark” about some of S&P’s grading methods well after 2008.”[4] Behind the duplicity lay the strong gravity of the temptation to exploit the conflict of interest. Ceresney found “a deep cultural failure at S&P and a failure to learn the lessons of the financial crisis.”[5] The cultural element in particular points to the existence of the temptation, though a cognitive warping, which could be behind the learning deficiency would also point to a desire to continue to exploit the ongoing conflict of interest.

Instances of lying or even a mendacious organizational culture can also indicate the presence of a strong temptation. In early 2011, for example, S&P employees told investors that ratings on eight commercial-real-estate bonds were based on specific conservative criteria. Actually, the firm used a less conservative methodology, according to the SEC. “S&P misled market participants into thinking that the ratings for their investments were better and that their investments had more protection than was actually the case,” according to the office of the New York Attorney General.[6] The motive? S&P got about $7 million to rate and conduct surveillance on just six of those transactions. In other words, S&P managers slighted the firm’s stated benefit to the public for the sake of more private gain for the firm.

Even after S&P updated its rating methodologies and changed its senior management after 2011, the firm published, “Estimating U.S. Commercial Mortgage Loan Losses Using Data From the Great Depression,” which the SEC found is “a false and misleading article” that claimed that triple-A rated bonds could withstand Great Depression-era levels of systemic risk using a revised methodology even though the data that S&P actually used was “decades removed” from the 1930s.[7] That the lie was even in the title itself points to an organizational culture firmly ensconced in the conflict of interest. In particular, by misrepresenting marketing as science in order to gain financially at the expense of the investing public so brazenly, the managers at S&P were clearly at odds with their own public asseverations that the public could indeed rely on the additional internal-safeguards could be trusted.

The sordid culture ensconced in exploiting the conflict of interest continued on past 2012 to at least June 2014, during which time S&P “also failed to follow internal policies around the surveillance of previously rating residential-mortgage deals,” even as the firm agreed to an “extensive undertaking to improve its internal controls,” according to the SEC.[8]  The lesson for the American public is that internal safeguards in a company are no match for a structural conflict of interest. In fact, claims that additional policies and procedures are in place and will be sufficient can be sheer marketing (i.e., window-dressing)—essentially a subterfuge designed to render exploitation of the underlying conflict of interest easier rather than more difficult.

In conclusion, human nature itself is no match for the institutional conflicts of interest—especially those whose exploitation can bring with it great wealth. Going the route of strengthening internal safeguards is thus insufficient, and may even facilitate the exploitation. Even though redesigning an institutional system, such as the relationship between rating agencies and the issuers of financial securities to be rated, entails a great deal of effort, it is necessary to stop exaggerated private gain from compromising promised public benefit.

1. Timothy W. Martin, “S&P Lowered Ratings Bar, SEC Says,” The Wall Street Journal, January 22, 2015.
2. Ibid.
3.  Ibid.
4.  Ibid.
5. Ibid.
6. Ibid.
7. Ibid.
8. Ibid.