Macaskill on markets: Stockholm syndrome at S&P
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Macaskill on markets: Stockholm syndrome at S&P

Standard & Poor’s met its late-April deadline for a response to a US Justice Department suit accusing the agency of fraudulently rating CDOs with an energetic rebuttal of the case for the prosecution.

S&P’s legal team, which includes noted First Amendment lawyer Floyd Abrams, made a convincing argument that the US government was guilty of over-reaching with its allegations of a scheme to defraud by the rating agency. The lawyers raised some eyebrows with a key rebuttal point that boils down to the argument that S&P had as much right as any corporation to indulge in meaningless and overstated promotion of its product line. This was backed with recent precedent, including a ruling last year in a separate case against S&P where a judge described statements about the integrity, credibility and objectivity of the firm’s ratings as “the type of mere ‘puffery’ that we have previously held to be not actionable”.

The puffery dispensation is a line of defence that might help S&P to undermine the government’s case and strengthen its hand in any settlement negotiations, although it certainly will not do much to improve client confidence in the rating process, or to revive staff morale at the beleaguered agency.

This line of rebuttal also fails to address one of the central problems that developed during the worst excesses of the credit boom and still endures today: Stockholm syndrome as a feature of the relationship between rating agency staff and the debt issuers who pay their bills, especially when those issuers are also bankers.


Stockholm syndrome is a form of psychological bonding where hostages form emotional ties to their captors. It is named after a bank raid in Sweden in 1973, where hostages developed a curious attachment to the robbers who held them captive for almost a week. A financial market equivalent to Stockholm syndrome is not normally a problem in the relationship between rating agency employees and traditional debt issuers such as corporate treasurers. There is certainly potential for a conflict of interest, given that issuers pay for ratings; or simply for conflict, as borrowers complain that a rating downgrade was unjustified. The guidelines for the relationship are relatively clearly drawn, however.

A warping of this relationship between rater and rated began with the dramatic growth in the collateralized debt obligation market between 2000 and 2007. CDOs are collections of securities, so the responsibility for paying rating agency fees shifted to the banks that structured new deals. S&P, Moody’s and Fitch developed a lucrative business line in providing ratings for CDOs. As the US Justice Department noted in its case against S&P, the agency was able to charge up to $500,000 for each cash CDO deal, and $750,000 for a synthetic CDO that used credit default swaps to create a derivative-based deal with comparable exposure. S&P generated $182 million of CDO revenue in 2006 and $203 million in 2007, the last year before the structured credit market crashed.

The growth in this market as a revenue source for S&P and the other rating agencies (S&P had more than doubled its CDO income by 2007 from an already strong base of $96 million in 2005) helps to explain the motivation of staff to keep deals flowing, even when it was becoming apparent that an unsustainable credit bubble was developing.

But there was something else going on. The process of CDO rating brought agency staff into frequent contact with Wall Street and City of London bankers who were among the most aggressive employees at their firms during a powerful bull market. Credit structuring managers were not just among the biggest revenue producers at their banks, although that was often perceived to be the case – at least until the 2008 crash wiped out years of prior profits. They were also widely viewed as the most creative minds on Wall Street, before financial creativity was itself downgraded as an asset.

This seems to have cast something of a spell on rating agency staff. Agency employees knew perfectly well that their contacts on Wall Street were far more highly paid. Even if they could not earn the big bucks, though, rating agency staff at least wanted to earn the respect of the top dogs of Wall Street, which led to a dangerous adoption of group-think.

The divergence in attitudes to rating agency employees who were seen to ‘get it’ by their Wall Street customers and those who were not was striking in two separate credit market roundtables I hosted in 2005. In the first roundtable the rating agency representative was a managing director from Fitch. His pronouncements were deliberate and not always to the point, and he seemed slightly mystified by some of the more esoteric structures that were arriving in the markets at the time. His comments were greeted with eye-rolls and sighs by some of the banking and hedge fund luminaries who were also in attendance (including bankers from firms no longer with us, such as Bear Stearns and Lehman).

At a second roundtable later that year, the rating industry representative was David Tesher of S&P, who received a quite different reception. Tesher clearly spoke the language of his Wall Street clients. He was openly commercial in debating business prospects for the industry, which put the bankers at ease. His discussion of a future need for rating agencies to provide credit estimates for pools of unrated collateral to create new types of CDOs was also music to their ears.

The perception that Tesher became too close to the industry he rated – in a form of Stockholm syndrome, given that the excesses of Wall Street tarnished the reputation of rating agencies – is a key part of the US government’s current case against S&P. Tesher and his boss, Patrice Jordan, are portrayed as effectively working to overrule the concerns of more junior analysts at the firm in order to generate more CDO business, in what the Justice Department describes as a scheme to defraud investors.

Tesher also fell prey to what might be called Tom Montag syndrome, or a regrettable tendency to express concern in unusually vivid terms in an email that is later used by the government in a legal case.

Montag remains a senior banking industry figure today, as co-chief operating officer of Bank of America and perennial threat to the job security of current CEO Brian Moynihan. But Montag is better known outside the industry for his email description of a CDO put together by his former employer Goldman Sachs as “one shitty deal”.

Tesher made a similar blunder by observing to S&P colleagues internally in late 2006 that: “this market is a wildly spinning top that is going to end badly”.

The US government seems particularly piqued that Tesher kept pushing for an increase in CDO rating business after this observation. This might not be evidence of fraud, as the government contends, but instead of Stockholm syndrome on the part of S&P – a problem that can be just as harmful and tough to combat.

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