Standard & Poor’s, the Wall Street bond rater, was defending itself in federal court from an accusation of fraudulent bond rating. The Department of Justice was arguing that S&P’s stamping of triple-A on junk securities amounted to an abandonment of its public promise to be independent, objective and disinterested. Last week, S&P’s attorney replied that promises of that kind were mere “puffery.”
“It is a remarkably cynical argument,” said Dow Constantine, King County executive.
Constantine had earned the right to make a Bronx cheer. King County had already sued Standard & Poor’s, Moody’s Investors Service and Morgan Stanley over triple-A’s on junky securities. In April, the parties reached a settlement under which King County was paid but could not say how much.
Here’s what happened. The county runs a bond fund, currently $4.5 billion, to hold the money it and other local governments collect in taxes. In 2007 the fund held $100 million in high-rated IOUs from two European “structured investment vehicles” that, unknown to King County, had loaded up on dodgy American mortgages.
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The “vehicles” went bust. They eventually paid out 60 and 65 cents on the dollar, respectively, leaving King County’s fund $38 million short.
Most holders of the IOUs, said Constantine, “just wrote off their losses and walked away.” King County did not.
It was a lot of money. Besides, the county had dealt with the rating agencies over its own notes and bonds. “We spend an enormous amount of time going through an extensive examination to receive a triple-A rating,” Constantine said. King County had played by the rules. It was not interested in being cheated by people who didn’t.
King County joined other institutional investors and sued the investment bankers and bond raters, demanding restitution of $708 million. On April 26, the defendants settled the case for a reported $225 million. It wasn’t the full loss. Of Standard & Poor’s share of the settlement — $77 million — King County’s attorney, Dan Drosman of Robbins Geller Rudman & Dowd, San Diego, said he knew of no similar settlement that large.
The federal case now pending is asking for $5 billion. That’s punishment, not restitution. It’s not reform, either. The raters were corrupted; the more interesting question is how to prevent it from happening again.
King County’s attorneys say the problem is that issuers pay for the rating of their own bonds. A seller-pays system has an inherent conflict of interest. That problem, however, was managed for decades. The seller-pays system also provides bond ratings free to the public. It is not obvious that there is a better alternative.
An answer may be in the ownership structure. In hearings in 2010, former employees of Moody’s Investors Service said the company had long had an academic culture, but that the culture had changed when the company went public on the stock exchange. Maybe Wall Street bond raters should be privately held, as they once were (and by the right owners). Maybe they should be not-for-profit. They must be independent of the government, because they rate the government’s debt.
I asked Constantine what he thought. “I’m not sure I have an answer,” he said. “But if no one is able to rely on the word of the rating agencies, then one of the underpinnings of the system starts to collapse.”
Either the existing system is made to work, he said, “or some other system needs to emerge.”
Bruce Ramsey’s column appears regularly on editorial pages of The Times. His email address is firstname.lastname@example.org