Attorney General Andrew Cuomo warned that his office plans to sue the largest online brokerage firm for civil fraud over its marketing and sales of auction-rate securities to clients.
Cuomo is also going after the ratings agencies, along with many others, for basically rating securities as AAA when they subsequently many such securities, primarily MBS related to housing, defaulted. A AAA rating has a 0.03% ish annualized probability of default. My problem is that this is a mistake, not criminal. While Moody's may have been overly incented to rate these securities highly, such an incentive has existed since the beginnings of the industry, and many other failed rating agencies neglected this at their peril (remember Duff & Phelps?). So, it's a standard incentive problem that I don't think is helped by piling on after the fact.
By itself it would not be so bad, it's just that going after brokers for selling AAA securities because they turned out riskier than expected means that now the rating agencies, and brokers, have to 'underwrite' (ie, evaluate and due thorough analysis) the same securities. It is a fact that the senior piece of some capital investment will have a low probability of default, due to the value of the underlying business. For example, if you lend someone $100k to buy a house, and the house has an independent appraisal of $300k, the probability you will lose any money on that $100k is very small; for a large portfolio, basically absent. To now say that everything must be evaluated by everyone just creates waste, because the costs are too great, the benefits too small. Remember, a growing economy comes from doing more with less, and a large part of this is in information processing. We take for granted real GDP growth, but improved financial efficiency—innovation!—is part of that. The only way to guarantee no more blow ups is to guarantee no more growth, a poor bargain (Gillian Tett's book Fool's Gold seems to think innovation is something to be discouraged).
There should be a vibrant sector of 'informationally insensitive' assets that have minuscule default rates. Such assets will be hypothecated by banks when deposited as collateral, making them effectively part of the monetary base. It's unavoidable, in the same way factional reserve banking is unavoidable.
I hope they remember that the Fed and all the regulators considered mortgages low risk because of their historical track record, which had minor losses in aggregate. No asset class has back-to-back surprises, so doubling down on mortgages is rather ahistorical from that perspective. Remember Commercial Real Estate? After its vicious 1990 cycle, default were historically low for the next 15 years (lot's of concern now, to be sure, however). Better to focus on other assets that have historically been safest. Why not raise the risk levels for municipal bonds, state bonds, even US government bonds? Clearly these have a potential for massive failure in spite of their golden track record. After all, many banks defaulted after the panic of 1838, surprising the Europeans who thought this unimaginable after they seemed so strong during the earlier panic of 1819. But that would cut into the incentives of the regulators, not rich bankers (all 'bankers' are now caricatured as Goldman Sachs employees making $700k/year).
You make a good point that the ratings agencies have responded to "incentives"/ratings fees for a long time.
You must have a good sense from your own experience of how accomodating some ratings agencies were with their letter ratings of corporates and some agencies. My only experience with the ratings agencies came from tranching up CDOs. The folks I dealt with in London were quite bright and committed to getting deals done. I think in many cases "they" recognized there was no data with which to frame expectations....either one had to say, as a rater, no data no deal...or, let's find some data, a methodology and let's get paid.... Upton Sinclair supposedly once wrote/said "it is difficult to get a man to understand something when his job depends on not understanding it"...Cuomo faces a situation where the potential return to his political capital is quite high from not understanding the nuances that you refer to....
".or, let's find some data, a methodology and let's get paid"
I imagine that's the attitude that has Cuomo concerned. Add to the mix the brokers' knowledge of the raters' attitude and it's pretty damning.
Admittedly the WSJ article doesn't get to the heart of the matter, but the title of your post is misleading.
They key point in the allegation is not that Schwab is being sued for selling AAA paper but that the auction-rate securities (ARS) were "[promoted] to customers as cash-like investments" (WSJ) when they in fact were not.
An ARS is a long-nominal-maturity floating rate instrument whose interest rate is supposed to be reset in regular (say weekly) auctions. *If* the auctions all take place successfully an ARS does behave much like cash. Notice the difference between this and a fixed-rate AAA MBS--nobody would describe a long-maturity fixed-rate AAA MBS as "cash-like".
The key claim in the suit is that the customers were not made aware that there was any risk that the auction might fail, nor of what would happen if the auctions failed. Obviously the failure of the auctions turns a "cash-like" instrument into a long-maturity bond.
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