Today I was reading the The Ohio Funds’ Memorandum of Law in Opposition to Defendant Rating Agencies’ Motion to Dismiss, which is the legal document prepared by the Attorney General for the State of Ohio on behalf of the Ohio Police & Fire Pension fund, Ohio Public Employees Retirement System, State Teachers Retirement System of Ohio, School Employees Retirement System of Ohio, and the Ohio Public Employees Deferred Compensation program. It is interesting in its own right but also raises questions of the tyranny of bond markets and the need to conduct fundamental (not window-dressing) reform of the way our financial institutions and governments operate. These thoughts then took me back to Europe and the proposed bailout of Greece by its Eurozone colleagues. All these topics are interwoven and reflect the sheer stupidity of the way we constrain our monetary systems. Rather than being vehicles that can liberate us from poverty they have been designed to invoke harshness and disadvantage for most and untold wealth for a small minority.
Note: the link above gives problems unless you download the file – right-click and select Save this link as in Firefox. Then the saved PDF file can be opened and read.
The defendents in the case are the criminal credit rating agencies – Standard & Poor’s Financial Services and its owner The McGraw-Hill Companies, Moody’s Corp and Moody’s Investors service, and Fitch Ratings.
Lawyers for the ratings agencies argued that the case could not be heard because the:
… Plaintiffs’ claims must be dismissed because they are “barred” by the First Amendment. In support of this argument, Defendants claim that the Sixth and Tenth Circuits have pronounced all credit ratings to be “opinion speech” that is non-actionable in any context, thus granting Defendants “absolute immunity” from any claims related to their ratings.
The WSJ covered the general issue as to whether the US constitution guaranteeing free speech applied to these cases last year in this article. They noted that:
Historically, the answer has been yes. But that protection is being questioned amid allegations that the firms had conflicts that encouraged them to give unduly rosy opinions about the creditworthiness of securities backed by subprime mortgages … To get around the Constitution, judges have ruled, a plaintiff suing a rating agency would have to show that a firm not only made false statements, but also did so with “actual malice” … [in relation to a case in Connecticut against S&Ps their company] … McGraw-Hill denies wrongdoing in the Connecticut case … [and said any claims to the contrary] … “… would result in an erosion of analytical independence” … [however, lawyers say that the] … Rating firms … could have a hard time claiming free-speech rights if courts construe their ratings of mortgage-backed securities to be akin to private commercial transactions.
The Ohio case is interesting because the legal submissions give a lot of detail as to how the ratings agencies were involved in the creation and proliferation of the financial derivatives that eventually caused the crisis when they collapsed. I realise that the lawyers have different ways of twisting facts to fit into the arcane precedents that may protect the credit-rating agencies. But to a non-lawyer such as me, the operations of the credit-rating agencies outlined in the statement of facts goes well beyond “opinion”.
Here are some selected quotes which will give you a pretty good idea of how these products were originated and who did what. After noting that the credit-rating agencies were key influences on “both the prices at which securities sell and the investment decisions of purchasers”, the latter who relied on the “(a)gencies to be impartial and honest arbiters of risk”, the Attorney General’s Memo said the credit-rating agencies:
… worked side-by-side with securities issuers to package opaque asset-backed securities (“ABS”), virtually preordained to have false and misleading investment grade ratings when they were sold to members of a limited class of qualified investors … In purchasing the ABS … namely residential mortgage-backed securities (“RMBS”) and commercial mortgagebacked securities (“CMBS”), the Ohio Funds did not know that the Rating Agencies’ essential and lucrative role in structuring these securities reduced the AAA ratings to little more than a rubber stamp of products that Defendants helped design.
The point being made is that credit-rating agencies were involved from the very beginning in the origination of these dodgy products rather than coming in once they were ready for marketing and giving their risk assessment based on the intrinsic nature of the products.
Indeed, the credit-rating agencies “were co-architects of the ABS” and their “highest ratings were required for the issuers to sell these securities” to the multitude of retirement and other funds. The Memo notes that “the ABS offering documents explicitly stated that the securities would issue only if one or more of the Defendants assigned their highest initial investment grade rating”.
So, the market was created by the AAA ratings and the retirement and other funds which were taken down in the meltdown would not have been able to purchase these products without those ratings.
The Memo notes that:
After receiving an issuer’s rating demands, the Rating Agencies worked with the issuer from start to finish, which included designing the credit enhancement aspects of the securities’ capital structures, in an effort to support the mandated ratings … Far from the unbiased and trustworthy analysis that Defendants knew investors like the Ohio Funds relied upon the Rating Agencies to provide, the ratings process became a negotiation between Defendants and issuers that enabled the ABS purchased by the Ohio Funds to issue with inflated AAA ratings.
In other documents (not available) the credit-rating agencies lawyers admitted they “knew it was wrong to subvert their objectivity and independence to the issuers’ demands, but the fees at stake proved too great for the Rating Agencies to resist”.
In this regard the game was not risk assessment but a “self-described ‘race to the bottom’ pursuing the largest share of the exponentially greater fees available for designing the ABS in exchange for assigning their highest investment grade ratings to these securities” – the so-called “market share war”.
So just how much was involved in the pursuit of free speech?
On page 25 of the Ohio AG Memorandum you read that:
From 2002 to 2006, S&P’s revenues increased by more than 800% based upon its work in structuring and rating structured finance securities, providing its parent company with more than 75% of its 2007 operating profit … From 2000 to 2007, Moody’s operating margins averaged 53 percent, outpacing global juggernauts like Exxon and Microsoft … In 2006, Moody’s derived more than 54 percent, or $887 million, of its ratings revenue from structured finance products … Fitch also brought in record profits for rating structured finance products, including $480.5 million in revenues in 2006 – 51 percent of its total revenue that year.
So while the credit-rating agencies might squirm their way out of this “legally” it is clear to me that their involvement was far more than meagre opinion. Reading the whole Memo is worthwhile if you are an information junkie like me.
The bottom line is that:
While serving as co-architects of the ABS and possessing undeniably superior knowledge of the risks presented, the Rating Agencies assigned inaccurate and inflated ratings to these securities knowing that the Ohio Funds and other members of the limited class of qualified institutional investors would rely upon the ratings in making their investment decisions.
This is why I call them criminals and their activities should be outlawed. Please read my blogs – Time to outlaw the credit rating agencies – Ratings agencies and higher interest rates – for more discussion on this point.
But the issues raised in the Ohio case (and others that are being mounted by States around the US) lead to the general question of how we allow bond markets to exert tyranny on nations to the detriment of their citizens.
Bond market tyranny
The news is now out today that the Eurozone offers Greece up to 30bn euros at a price well below the market rate.
So the German hard-line that the loan would not be subdised has been softened. Of-course, one of the problems of not giving concessional support would have been that no real gain would have been possible. The current bid rates are so skewed by the sovereign risk factor (which is purely a product of the nonensical monetary system that the EMU nations agreed to) that their punitive nature is a problem in itself.
The Eurozone deal will give the Greece government and while this might sound like an easing of the EMU hardline about “bailouts” etc just wait until you read the austerity conditions that will be attached to the IMF tranche accompanying the package. I will come back to that soon.
The issue of ratings agencies was considered in the UK Guardian last Friday (April 9, 2010) in the article – The tyranny of bond markets by one Kevin Gallagher, who was advocating that the US government should “get tough” on the agencies “as they rear their heads again”.
Importantly, while it is clear the credit rating agencies “played a big role in creating the financial crisis” the current problem is that “they are slowing the recovery”.
Gallagher says in this regard:
No one stepped in to regulate the agencies in the aftermath of the crisis. So they’ve reared their heads again, this time zeroing in on government debt. Many of the hardest hit governments, rich and poor alike, have borrowed funds in the bond markets to stimulate their economies into recovery.
Well, the rating agencies grade these bonds too. Many economists shake at the deficit fetishness that has overtaken the press and some members of the US Congress, warning that a fragile recovery from the crisis will do more harm in terms of investor confidence. Spending when times are bad, cutting spending when the economy is performing well, is good economics.
I wonder just how many mainstream economists are worried about the deficit fetishness that has gripped the world. Certainly, the arguments presented in the press are just constant rehearsals of the major conclusions that appear in mainstream macroeconomics textbooks. All the fears of rising interest rates and taxes and runaway inflation all come from the textbooks.
As an aside, I prefer the term deficit terrorism because it is more pointed than referring to the irrational, yet damaging attack on government fiscal support as a fetish. The general use of the term terrorism is fraught with definitional problems and disputes (see this discussion). So is a fighter seeking to free his/her people from colonial oppression and uses bombs and surreptitious attacks to instill fear a terrorist? That is the sort of subjective issue that gives international lawyers headaches.
But in the case of the fiscal terrorists there is no alternative interpretation of their actions which is acceptable. They would claim they are akin to freedom fighters trying to get the government off our backs and restore entrepreneurial zeal. But there is no logic in that claim. It is patently obvious that their attacks are undermining the capacity of governments to support jobs and private saving.
Anyway, the current focus on sovereign debt is certainly impeding the recovery in most nations and invoking severe damage that will last for generations in some nations, such as Ireland, Greece, Latvia, Estonia … to name a few of the hardest hit.
The point is that while the criminal rating agencies were profiteering from the release of the toxic debt products in the lead up to the crisis, they are now using their influence to punish governments that do not introduce severe enough austerity packages.
… the rating agencies are tyrannising governments for doing the right thing. It was Moody’s downgrade of Greece that pushed that country over the edge, and last week Fitch’s downgraded Portugal’s debt. Is Portugal next? In December all three agencies downgraded Mexico for not sufficiently raising taxes and that country has had its worst year since the Depression. Most strikingly, credit rating agencies have threatened to downgrade the debt of the UK and the United States – two countries that have never defaulted on their debts.
Gallagher gives his game away by the “doing the right thing” reference. The reality is that the rating agencies are tyrannising governments for doing the wrong thing – which can be read in two ways. The meaning I am of-course presenting is that agencies actions are compounding the errors that these governments or the supra-national monetary system in the case of the EMU are making.
This is the problem with sovereign debt ratings in general. They work against the responsible use of fiscal policy. The world has been hit by the largest recession in 80 years. Some countries have shrunk in national income terms by 20 per cent or more. Millions of people have lost their jobs and income and a good proportion of those people will be shedding assets built up over years of saving to maintain some semblance of solvency. Many have gone down harder than that and are now impoverished without anything of their past security.
The reason? A major aggregate demand failure that followed the collapse of financial markets. The answer: short-term fiscal stimulus of massive proportions was needed. The government that responded to the crisis by providing some fiscal support didn’t provide enough nor early enough. Their economies declined severely but they avoided a depression.
Many governments, so overwhelmed by the collapse of the automatic stabilisers (for example, tax revenue), came under instant pressure to control their “debt” and implemented austerity plans far to early.
Other governments, hemmed in by the nonsensical anti-people Stability and Growth Pact rules on fiscal policy and debt that bind treaty members in the EMU, have implemented very harsh austerity programs which will stall their chance of recovery for years and impose very severe imposts on the standard of living of their citizens. All unnecessary and blatantly destructive.
The rating agencies have compounded this problem by arguing for even greater austerity. Moreover, their threats to sovereign governments such as the UK and the US while irrelevant if the government’s resisted (Japan showed some 10 odd years ago) will also undermine the standards of living in those nations because governments will try to keep the agencies sweet via introducing totally unnecessary austerity initiatives.
In the current proposal to introduce financial market regulatory reform in the US, which will filter out to other nations if passed, there is a special section devoted to credit-rating agencies. You can see the detail of the proposed legislation HERE.
The Obama proposal seeks to increase the transparency of the ratings system by creating an Office of Credit Ratings administered by the Securities and Exchange Commission (SEC) and make it easier for dudded investors to sue the agencies for “gross negligence” rather than “actual malice” (as noted above in my discussion about the Ohio case). These grounds would be less onerous for litigants seeking successful claims against agencies.
But as Gallagher notes in his article, the proposal is very weak on suggesting greater regulatory control of the credit rating agencies where there are “conflicts of interest” – highlighted by the so-called “issuer-pays” revenue model. That is, the agency gets paid to rate the product of a company rather than gain revenue from the investors.
There are other major failings with the reform bill (no competitive clauses etc).
Further banking reform is also needed in relation to the behaviour/role of the credit-rating agencies. At present, banking regulation allows the banks to hold “speculative assets” that are rated as investment grade by the agencies. Why? Because we seem to believe the judgement of the criminals is an indication of safety (low risk).
Now we know that the agencies lie about the risk just to get their hands on the huge financial rewards offering this sort of regulatory constraint on the banks needs to be scrapped and a much harsher rule introduced.
Some might argue that the un-competitive nature of the ratings industry is the problem – it is an industry dominated by three firms. This argument would suggest new entry be encouraged to force the agencies to improve. I disagree. The fundamental concept of a third-party passing judgement for return on the products of a bank or any financial institution is crazy.
I would eliminate the capacity of the banks to speculate in derivatives markets and force them to demonstrate the security of their portfolios themselves. They should introduce acceptable measures to assure investors their asset structure is sound.
Please read my blog – Operational design arising from modern monetary theory – for more discussion on my proposal to limit the operations of the banks, which would also reduce the capacity of the credit-rating agencies to influence financial markets.
Euro bailouts and Greece
Which brings me back to Greece which the credit-rating agencies have hammered in recent weeks. This has exacerbated the already grim situation facing the Greek people suffering under the ridiculous EMU rules agreed to by their previous governments and re-endorsed by the current (relatively new) government.
It would be one thing if the Eurozone loans were at concessional rates and that was the end of it. This would reduce the reliance of the Greek government on the private bond markets and therefore render the rating agency assessments irrelevant (just like in the case of a sovereign government).
As I note below, the problems facing Greece are endemic to the organisation of the Eurozone monetary system and these sorts of loans are just band-aids. But, given the present structure, the offer of a credit line at concessional rates (but still above the IMF bailout rate) is better than no offer.
But the bigger problem is that the IMF have become involved. This is the organisation that imposed pro-cylical policies on low income countries as the recession deepened. Please read my blog – IMF agreements pro-cyclical in low income countries – for more discussion on this point.
The IMF has a long-history of damaging the poorest nations. The so-called structural adjustment programs (SAPs) entered the scene in the late 1970s with the debt crisis that engulfed the world. This was constructed as a crisis for the developing nations but it was really a crisis for the first-world banks. The IMF made sure the poorest nations continued to transfer resources to the richest under these SAPs.
The overwhelming evidence is that these programs increase poverty and hardship rather than the other way around. In the blog I just mentioned I provided a graph that shows Gross National Income per capita, which, in material terms is an indicator of increasing welfare. The data which comes from the World Bank’s Development Indicators show that Latin America and Sub-Saharan Africa (which dominates the low income countries) were the regions that bore the brunt of the IMF SAPs since the 1980s.
While the high income countries enjoyed strong per capita income growth over the period shown (since 1980), Latin America (and the Caribbean) has experienced modest growth and the low income countries actually became poorer between 1980 and 2006.
The two trends are not unrelated. The SAPs are responsible for transferring income from resource wealth from low income to high income countries.
There were many mechanisms through which the SAPs increased poverty. First, fiscal austerity is almost always targetted at cutting welfare services to the poor – which often means health and education (the IMF claims that educational and health cuts no longer happen). But moreover, the cuts prevent sovereign governments from building public infrastructure and directly creating public employment.
Second, public assets are typically privatised. Foreign investors often benefit signicantly by taking ownership of the valuable resources.
Third, contractionary monetary policy forces interest rates up which often discriminate against women who survive running small businesses.
Fourth, export-led growth strategies transform rural sectors which traditionally provided enough food for subsistance consumption. Smaller land holdings are concentrated into larger cash crop plantations or farms aimed at penetrating foreign markets. When international markets are over-supplied, the IMF then steps in with further loans. But the original fabric of the land use is lost and food poverty increases.
Fifth, user pays regimes are typically imposed which increases costs of health care, education, power, and in some notable cases, reticulated clean water. Many of the poorest cohorts are prevented from using resources once user pays is introduced.
Sixth, trade liberalisation involves reductions in tariffs and capital controls. Often the elimination of protection reduces employment levels in exporting industries. Further, in some parts of the world child labour becomes exploited so as to remain “competitive”.
And so Greece is about to go down that route – should it actually accept the credit line being proposed by the Eurozone in partnership with the IMF.
The concessional advantage of borrowing at 5 per cent instead of at 7.5 per cent which is the yield that Greek government bonds reached last week as the tyranny of the bond markets tightened it ugly grip on the Greek people is clearly a good thing, given that under the EMU arrangements the Greek government is not sovereign and has to finance its spending.
But the austerity program that will emerge on top of the self-inflicted plan imposed by the Greek government itself to satisfy the bullies in Brussels, which should actually read Berlin, will more than offset this advantage.
The point is obvious. The Eurozone is in a very fragile state with respect to growth potential. Government fiscal positions have been affected by the automatic stabilisers – particularly the decline in tax revenues. While that sounds bad, it is actually a good thing and part of the demand-supporting structure of fiscal policy. When private demand turns down, the stabilisers push the deficit up to provide some support from overall aggregate demand.
But in the context of the madness of the EMU the public deficits which are supporting what growth there is are bad and have to be cut. Any further pressure to cut this fiscal support will backfire. This situation will affect all nations embarking on fiscal austerity plans in the context of weak private demand but it will impact on EMU nations more significantly.
We can expect the Greek deficit to rise as their tax revenue collapses further if they implement austerity initiatives. Then, given the mad logic of the EMU and the role that the credit-rating agencies is allowed to play, the vicious circle will get harsher.
The rising deficits will promote greater calls from the EMU to contract the fiscal position and even larger yield spreads for the weaker nations of the Eurozone. Then the bailout will have to be larger and so it goes.
If we had have set out to invent a monetary system that was designed to inflict maximum damage on the citizens of the country signed up to it then the EMU would be pretty close to what we would come up with. Total madness. And allowing the IMF to get their grubby claws into the mix takes us into the realm of insanity.
The danger is that while Greece goes further down the drain, it will bring the other EU nations down with it. And that will not exempt the biggest bully of them all – Deutschland. Then imagine the bailout that will be required.
Growing European fanaticism
Economic crises always bring out the right-wing elements that lie subdued in better times in most nations. In Germany, there is one Thilo Sarrazin who is a board member of the Bundesbank and his views have hit the headlines recently. They represent the not so subtle view that seems to be growing in Germany again – the same sort of view that led to boys in uniforms marching around doing evil in the 1930s.
As background, this article (if you can read German) tells us that Sarrazin thinks the German unemployed should only have 140 euros per month (which is the Hartz IV quota) to live on. He also considers the main problem is Greece to be laziness.
In this article – Thilo Sarrazin – racist hero – you learn that Sarrazin told an interviewer that:
A large number of Arabs and Turks in this city, whose number has grown through bad policies, have no productive function other than as fruit and vegetable vendors … Forty per cent of all births occur in the underclasses. Our educated population is becoming stupider from generation to generation. What’s more,
they cultivate an aggressive and atavistic mentality. It’s a scandal that Turkish boys won’t listen to female teachers because that is what their culture tells them … I’d rather have East European Jews with an IQ that is 15pc higher than the German population.
Charming bloke, to be sure. He is apparently an instant “hero among both conservatives and right-wing extremists in Germany”.
Even the mainstream newspaper Frankfurter Allgemeine called him a “brave truth teller”. According to a public poll “51% of Germans agree with Sarrazin’s comments”.
See also, this article – Bundesbank official under police investigation after blasting Turks for ‘conquering Germany’.
Our friend Peter Sloterdijk who I discussed last week in this blog – I just found out – state kleptocracy is the problem – also supports the line taken by Sarrazin (Source if you can read German).
It is a scary place to be if you are not white-haired and blue-eyed! Humans never learn from the past.
Digression – our booming Australian economy
Regular readers will know I am running a campaign against all the hyperbole coming from the bank economists and others about how we are close to full employment and the economy is dangerously over-heating. And … therefore we need higher interest rates and a signficant fiscal withdrawal.
This is despite the fact that we have 12.8 per cent of our will labour resources are underutilised and GDP and employment growth is sluggish.
Further confirmation of my view that the Australian economy is not dangerously overheated and needs continued fiscal support came from the Australian Bureau of Statistics Housing Finance release.
It showed that home loans in February fell for the fifth consecutive month (1.8 per cent in February) with the January figure revised downward to a staggering 7.3 per cent drop.
One of the often-quoted bank economist, who is among those who has been talking things up, said today (Source):
It’s a bit of a puzzle.
Why doesn’t he just say … we haven’t got a clue? Answer: his company wouldn’t get their logo in the background of the news reports (that is, free advertising) if he did.
I liked this quote from the Sydney Morning Herald article wrapping up the Masters golf tournament. While pondering about the return of Tiger Woods the journalist asked:
What did he take from this week, in which he finished with a 69 to share fourth on 11-under 277, five shots and one family adrift of Mickelson?
That is enough for today!