You don't need boxes of emails to realize that the larger defense of S&P and the other two traditional credit raters, Moody's Investors Services and Fitch, is weak to nonexistent, and it has been for over four years now. There's really only two choices: the industry when it came to mortgages either sold itself out to its customers, the Wall Street firms, or it was simply massively wrong, which to a firm that peddles intellectual content is a problem and one that's not really helped by the fact that nearly everyone else missed the subprime bubble too. None of that is really in dispute. What's in dispute, despite the federal civil charges that have just been leveled against S&P and its parent, McGraw-Hill, is whether the credit rating organizations understood that they were wrong, say in 2005 or 2006, and ignored it. That would be fraud and McGraw Hill would have to pay for it, undoubtedly followed by Fitch and Moody's.
True, the federal government could use a billion dollars and, yes, if fraud turns out to be obvious -- emails in The New York Times seem ambiguous to me -- then perhaps punishment can provide deterrence. Or maybe not. But the real story here is that this case, despite the insistence that the feds are finally going after someone or something responsible for the meltdown, doesn't get us any closer to fixing the problem. The credit raters are operating pretty much as they did before the crisis (mortgage-backed securities have not come back) and the structural setup with Wall Street remains intact. Dodd-Frank mostly punted on the credit raters and various reform efforts -- Al Franken's notion of ratings being assigned randomly or attempts to inject more competition into their ranks -- have not taken root. Perhaps now some of these ideas will move forward, perhaps not. The raters retain a central role. It's something that a vast, global, decentralized, interconnected financial system built around data and markets needs to function.
There are two thorny problems buried here. First, is the economics of the business. Second, is the question of opinion in finance. We've seen both problems before, notably in Eliot Spitzer's crusade against Wall Street analysts in 2001. The parallels are remarkable; the resolution is unsettling. What did we have? A bubble that burst, a stock market and economy in retreat, a search for culprits and the exhumation of emails. Pretty much everyone understood that Spitzer had a case against some Wall Street analysts, from Merrill Lynch & Co.'s Internet cheerleader Henry Blodget to Citigroup's telecom booster Jack Grubman. Spitzer did reveal seamy conflicts between Wall Street stock research and investment banking, with the latter paying the bills and shaping the analysis. Spitzer came off a hero by driving a Wall Street settlement; but unlike the feds in the S&P case, he never took anyone to court and larger issues remained. The settlement stifled Wall Street research. Ties to banking were cut, leaving little economic support. Investors, institutional or retail, would not pay for the product: The free-rider problem always lurks. As a result, coverage for many companies was dropped, hurting both investors and the companies themselves. There are many reasons for the travails of the initial public offerings in the post-dot-com decade, but a shrunken research business is right up there. And for all the ballyhoo, the carnival of the Internet, with its opacities and conflicts, has not proven to be an adequate substitute.
Spitzer's Analystgate has proven to be prescient. It raised a number of questions about the role of analysis and research in finance. How can you prove that someone has sold his opinions for money or power or, in Grubman's case, a place for his children in a fancy kindergarten, if, in fact, those are the exact reasons folks take those jobs in the first place? You're on Wall Street not to help mankind but to make a living. Do political pundits never tailor their views to make a buck? This may well be why Spitzer chose not to take the research cases to court; he may also have been in a hurry to run for governor. But how do you prove intellectual dishonesty in a world ruled by continually changing markets? There is a popular conception that Wall Street is controlled by quantitatively driven geniuses, evil or otherwise, who spend their time calculating the future. Well, the quantitative part is true; but the ability to actually fix any but the most fleeting of truths through math is elusive, which explains why we have high-frequency trading. Math is a fragile bulkhead tossed up against heaving seas. Uncertainty rules; the future is murky. Today's reality is today's market prices; it will be different tomorrow. The market practitioner knows that notions of equilibrium favored by economists are only theoretical, and continually shifting. Nothing is fixed. Market truths are relative, temporary and in flux.
All that is not to say that conflicts do not exist, and that intellectual corruption doesn't emerge from those conflicts. They undoubtedly do -- in credit ratings, research, in nearly every business on earth, from professional athletics to advertising. Hell, look at Congress. But it's made worse by this profound uncertainty and relativism, which can lead, on the financial side, to cynicism and naked self-interest, a kind of modern sophistry. Moreover, there's a huge gap between public perception of Wall Street and reality, some of it provoked by the strutting self-image of Wall Streeters. The world believes Wall Streeters can read the future. They act that way. Look how rich they are, how smart, how powerful. They speak with utter certainty. Ask them where the market is going and they will tell you, over and over again; it's the Larry Kudlow Effect. But the truth is, they bob on fragile life rafts, liable to be swept overboard at any moment. They are wrong, like all pundits, a lot of the time.
All this leads us into the shadows of the human heart, which is where the emails come in. Were those calls -- on a Triple-A CDO or on Pets.com -- the result of objective, un-conflicted analysis, or were they shaped by other hands for other ends? (It's interesting to see the "punditocracy" rejecting the possibility of objectivity for itself, while demanding it for others.) Did you sell out? Determining this involves the juggling of circumstantial evidence, unless there's a bag of money and a video involved. Can corruption and objectivity coexist? What was your mental state? Was S&P dumb or corrupt or both? It's actually easier to accept corruption, since that's remediable; being simply wrong in a world of markets is scary because, as everyone knows and no matter what structural remedies are imposed, it will happen again.
Setting ratings is a difficult business, made tougher by demanding shareholders, pushy customers and a semi-oligopolistic industry structure. Yes, the raters should have done a better job, along with regulators, politicians, mortgage brokers, banks and Wall Street firms. Punishment may make sense politically, quieting for now critics who need to see bodies on the floor of the arena. But it won't solve the larger problem of predicting the future in an increasingly interconnected and uncertain world. The worst scenario: As finance grows ever-more complex, we grow ever-warier of offering opinions.
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