08/15/2009 05:12 am ET | Updated May 25, 2011

Calpers Sues Rating Agencies: Where's Obama? Where's Congress?

"The nation's largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by 'wildly inaccurate' credit ratings from the three leading ratings agencies.... Calpers maintains that in giving these packages of securities the agencies' highest credit rating, the three top ratings agencies -- Moody's Investors Service, Standard & Poor's and Fitch -- 'made negligent misrepresentation' to the pension fund, which provides retirement benefits to 1.6 million public employees in California."

New York Times

Finally, someone is going after the ratings agencies who were in up to their eyeballs in propagating the great fantasy finance fraud. The only surprise should be why it took this long for a lawsuit like this to be filed.

By helping the large investment houses and banks get AAA ratings for junk securities, these agencies did very well indeed. Moody's in fact had the highest profit margin of any corporation five years running from 2002 to 2007.

The Calpers (California Public Employees Retirement System) suit takes us into the heart of fantasy finance. For reasons almost beyond comprehension, the $173 billion public pension fund bought $1.3 billion worth of securities in 2006 that its managers could not possibly have understood. Those securities collapsed to near worthlessness during the crash and still are in sorry shape. Actually I do know why Calpers bought them -- they were AAA-rated and had a rate of return that looked good compared to the alternatives at the time. (They're not alone: Five Wisconsin school districts lost nearly $200 million in a similar scam. See The Looting of America. The first chapter featuring the Wisconsin school swindle is posted at here)

What did they buy? They don't know because, "Information about the securities in these packages was considered proprietary and not provided to the investors who bought them." Now that's gall.

Here's how this game was played. Large banks, investment houses, or other originators would come to a rating agency with a complex security embedded with loads of fees for the banks involved (of course). The securities often consisted of a set of bets on other securities that were not owned by the originators. The only way to assess their value was through complex modeling that, as it turned out, might just as well have applied to housing on Mars. The ratings agencies helped the banks construct the security so that it would seem, based on the Mars models, to be safe and secure, thereby worthy of an AAA rating. Then after it was "tested" by the model, the agency blessed it with the AAA rating.

At the time, everyone involved was extremely happy about the arrangement. The rating agencies got a nice fat fee, up to a million dollars per transaction (and there were a lot of transactions going on), for helping to tweak the Mars model. They also got their usual fat fee for rating the bond. The originating bank made tens of millions in fees for putting together the security and selling it off. And buyers like Calpers were happy to get the promise of a high return from a secure AAA-rated security, even though they had absolutely no idea what they actually were buying. (Bernie Madoff, are you smiling?)

When the value of junk debt stopped rising and then started to decline, the Mars models showed that these securities now were nearly worthless. In fact trillions of dollars worth of fantasy finance instruments that had made Wall Street fat and rich crashed in value all over the world. The banks became insolvent and we had to rescue all of Wall Street with trillions of loans, grants and guarantees to prevent the next depression.

So what are we going to do about it? Here's what the Obama and Congress seem afraid to do:

1. Prohibit the creation and marketing of any and all special derivatives until they are approved by a federal agency, just like we would approve a drug. What else has to happen to the world economy before we finally admit that this kind of financial innovation is guilty until proven innocent?

2. In any case, like dangerous drugs, no complex derivative security should be peddled within a thousand yards of a school district, public agency or any pension fund that is publicly owned or guaranteed by public funds.

3. Set up a "Public Option" rating agency that would have the ability to rate any and all securities, even those already rated by private agencies. This kind of competition would keep everyone on their toes. Imagine how Moody's would feel if it rated something AAA and the Public Option agency rated it as junk.

4. Slap a hard wage cap on the entire financial sector: No one can earn more than the President of the United States until the $13.1 trillion of subsidies are repaid by Wall Street to the US treasury. Not only is this fiscally sound but it would remove the temptation that regulators must feel when they know that if they shave a rating just a bit, the bank or investment house might hire them for ten times their current salary.

It would be easy to blame Calpers for buying something that was impossible to decipher. It certainly makes you wonder about their due diligence. But they were not alone. This junk was peddled successfully all over the world. In fact Morgan Stanley is doing it again. (See "Morgan Stanley Plans to Turn Downgraded Loan CDO Into AAA Bonds" )

The real problem is that fantasy finance inevitably leads to financial crashes, and those crashes are a disaster for the real economy. Along the way, many bankers get filthy rich. But when the game goes bust, it is we, not them, who are picking up the tab.

Our biggest problem right now is that the Administration and Congress seem unwilling to take on the financial community. The big boys on Wall Street are testing them to see who will blink first. Unfortunately, we're looking at a lot of fluttering eyelashes at 1600 Pennsylvania Ave and on Capital Hill.

Les Leopold is the author of The Looting of America: How Wall Street's Game of Fantasy Finance destroyed our Jobs, Pensions and Prosperity, and What We Can Do About It, Chelsea Green Publishing, June 2009.