Originally posted: Mar. 25, 2009

Zach Carter has an article up at The American Prospect detailing how the ratings agencies stand to benefit from the Term Asset-Backed Securities Lending Facility (TALF). TALF is the Fed program announced last winter (but just getting into action) that puts forth $1 trillion in non-recourse loans to holders of AAA rated asset backed securities (the “assets” here being a wide variety of new loans). The problem Carter highlights comes with that “AAA rated” part.

There are three main ratings agencies that essentially have the markets by the, err, bulls: Moody’s, Standard & Poor’s (aka S&P) and Fitch. Each agency has their own rating system but they’re fairly similar, with the top ten ratings being considered investment grade and AAA being the cream of the crop. The assignment of a AAA rating theoretically means that whatever it is stamped on- say a CDO pool- is low risk. All of this would be well and good if the credit agencies were behaving responsibly. Hint: they’re not.

These credit raters were also essential to the process of packaging sub-prime mortgages into extraordinarily complex securities that would later become the “toxic assets” trapped on the balance sheets of banks around the globe. The process began with investment banks buying hundreds of mortgages and packaging them together into a byzantine security to sell to investors. Since the sheer complexity of this new security rendered it effectively impossible to analyze, investors relied on credit ratings to determine just how risky it was. Fueled by a false confidence in rating-agency credibility, the market for sub-prime mortgage securities exploded between 2001 and 2006 from about $100 billion to over $1 trillion.

The ratings were bunk. Many mortgage-backed securities that earned AAA ratings — the highest grade a rating agency can bestow — turned out to be nearly worthless, and the value of the securities market plummeted 70 percent between January 2007 and December 2008…

There were two basic problems with the credit-rating agency business model. First, they were not paid by investors who used their ratings, but by the investment banks that created the securities. This gave the agencies overpowering incentives to inflate ratings.

Second, the agencies were not legally required to ask for the information needed to accurately rate securities. When that information was available, they often chose to ignore it, knowing that awarding high ratings meant generating big profits and that too much information could cut into revenues…

The New York Times ran a great article last year on the role Moody’s in particular had in the economic collapse. There was the reliance on unstable formulas, irresponsible optimism regarding the housing markets and the obvious conflicts of interest. The other two weren’t any better in their behavior. TIME named S & P’s Kathleen Corbet as one of the “25 People to Blame for the Financial Crisis“.

But what does all of this have to do with TALF? As mentioned above, the Fed requires the asset backed security pools to have a AAA rating in order for them to be awarded the non-recourse loan. And it is the big three agencies that will be providing those ratings:

…The central bank has made an inexplicable decision to outsource its analysis of the quality of these consumer loans to the very rating agencies that helped create the financial meltdown. Instead of staffing up to evaluate borrowers’ ability to repay new credit-card and auto loans, the Fed is simply agreeing to finance any investment in a consumer loan security that receives a AAA rating from at least two major rating agencies. Just as the rating agencies are starting to lose revenues as a result of their malfeasance, Treasury Secretary Timothy Geithner and Federal Reserve Chair Ben Bernanke are rushing in to flood them with business…

TALF is not only funneling money to the culpable, it is reigniting the securitization process that created the current economic firestorm. Credit-rating agencies have proven that they are more than willing to assign top ratings to economically destructive sub-prime securities. Under TALF, thousands of loans will be packaged into securities that are nearly impossible to analyze, with no quality assurance from anyone except discredited rating agencies. These securities will create artificial demand for consumer loans, encouraging banks to issue loans to consumers who cannot afford them, knowing full well that they can pass the loan off to investors financed by the government. This has already caused a disaster once. It’s hard to see how it will turn out better when the consumer loans are made amid near-depression economic conditions.

As if ratings arbitrage wasn’t enough of a problem before the crisis began. This setup echos the Geithner Plan in demonstrating the Administration’s unwillingness to properly restructure the carcass of the economic system before trying to resuscitate it.