So, since I’ve been railing here about how this administration would not prosecute any Wall Street firms over the various frauds committed during the recent (and continuing) financial meltdown, thought it only fair to point out an exception, a first. I’ve long held that there’s no chance of prosecution because, in a truly fascinating and amazing coincidence, the financial enforcement arms of the government are staffed and lead by people who used to work for Wall Street firms and generally intend to work for Wall Street firms once they’ve put in their 2-3 years of public service making sure nothing untoward happens to their once and future employers. 
Well, here’s some news: the financial instrument rating arm of S&P is reportedly getting sued. Let me offer one well contained huzzah. This could be a step in the right direction. I kind of doubt it.
Now, maybe this is the first small step in a bigger plan – maybe the prosecutors have explained to some mid-level lackey at S&P that he could be rooming with Bubba and Vinnie the Neck for the next 10 years, unless he cared to share with them the names of the people involved in making sure that S&P didn’t look too hard at those mortgage-backed securities, but instead gave them the AAA-rating Goldman and others needed them to have in order to sell them to unsuspecting retirement funds. Because there were dozens of people in those rating agencies that knew MBS were some seriously bad stuff well before they started to stink – math & logic insist this is so.
Then, the prosecutors could have a remarkably similar discussion with the people that lackey fingered. Lather, rinse, repeat, until you’re having a little talk with senior execs at Goldman – and at Treasury and the SEC, and maybe (let’s dream a little here) with a few Congressmen. Then – when Wall Street Presidents and CEO are doing time and having their assets seized, Treasury and SEC heads are rolling, and (dreaming again) Barney Frank has his retirement plans changed to live off our tax dollars in an entirely different and more confined way – THEN I’ll admit I was too cynical.
Until then, the more likely scenario is: The government prosecutors are under enormous political pressure to DO SOMETHING about all these Wall Street fat cats having worked the system in order to not just stay out of jail, but to make off with enough tax-payer funded plunder to make Black Beard blush. So, who can they go after, that calms the little people without really bothering the big boys? How about the rating agencies? Yea, because OF COURSE S&P wasn’t under ANY PRESSURE AT ALL to give Goldman and others the ratings on MBS that Goldman and others needed to pull off their scam – it’s not like Goldman pays them for the ratings, after all.
Oh, wait – they do.
So, prosecutors can bag S&P, hit them with a billion-dollar fine, nobody does any time, and everybody else – the real perps from Wall Street to DC – skate, to fund another reelection campaign another day.
Yard Sale of the Mind 
Mortgage Backed Securities really were a good risk. It has widely been known throughout the world that Americans pay their mortgages reliably. Therefore, buying that debt is a good investment pretty much guaranteed a revenue stream.
So what happened?
HUD required that a specified percentage of mortgages be to borrowers below a certain fraction of the median wage. This was to combat what was then called “red-lining” in which banks avoided lending to people unlikely to pay back the loan. The target for 2005 was that 52% of mortgages had to go to those with income below the median and that 22% had to go to those below 60% of the median.
To help satisfy HUD affordable housing goals, Fannie and Freddie funded hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down. Between 2000 and 2005, Fannie and Freddie met HUD goals every year.
But in order to sell this debt, the risk was spread out and the mortgage “bundles” mixed a little bit of the affordable housing mortgages in with the normal ones. This worked for many years, from 1992 to 2008. As long as home prices continued to increase, the investments paid off. S&P and the other ratings firms would have had no evidentiary reason to downgrade the MBS (and likely would have been accused of prejudice if they had).
Once the speculative bubble burst, the bundles containing the (now-called) “toxic loans” found themselves in the position of the barrel containing a few bad apples. The bad loans dragged the otherwise good bundle down with it. Too many borrowers found themselves with negative equity and the regulatory system collapsed.
Bad faith and wickedness are not required. Firms coerced into making risky loans in the name of expanding home ownership had to do something to not lose their shirts selling the securities. The motives of HUD were good (even if their grasp of cause and effect was not) and for sixteen years the system appeared to defy gravity — long enough for everyone to convince themselves that economic laws had been suspended.
I’d buy all that, except that there’s a pricing model that underlies mortgage-backed security based on the way Black – Scholes is used for option and derivative pricing. In this model, there are 4 key variables. 3 are objectively determinable: time, the price of the asset upon which the option is secured and the risk-free interest rate. The last is an intelligent guess based on analysis of historical data: volatility.
It’s been a couple decades since I worked through the math, so I risk making a fool of myself in front of a real mathematician, but as I recall, it was a typical business school exercise to plot out values in such a way as to produce an asymptotic curve. Very safe investments – let’s call them AAA – had very little area out under the curve where Bad Things might happen.
And you could Monte Carlo that puppy, and say: there’s a 99.9% probability that this investment won’t loose more than 10% of its value – and there’s your AAA investment.
BUT – play with the volatility value, and things can quickly go crazy – you get scary amounts of area under that curve – Bad Things were likely.
Now, the analysts at S&P sure as heck know this. If they chose to look only at the 15 years before 1992 – which is what they did – well, volatility was really low, and so MBS were really safe. But if they chose a 50-year or 75-year period, or even a different 15 year period, Bad Things were much more likely to happen, and those MBS could not be rated AAA.
This situation is compounded by high correlation between problems in the economy, housing prices falling and people defaulting on their mortgages. Not only do housing prices go down when economic activity slows, but people tend to get laid off, which raises defaults on houses that, because the economy is down, cannot be sold for enough to cover the outstanding loan balance. Bit of a feedback loop.
So: the smart guys at S&P and other rating agencies were deliberately choosing a data set for analyzing volatility that permitted them to produce AAA rated MBS. Did anyone notice? Why, yes they did – the guys at Goldman, who placed huge ‘insurance’ bets that would only pay off if the MBS failed. They placed these bets while simultaneously selling AAA MBS to school teacher’s retirement funds.
So, no, I’m not buying the innocent mistake theory. Bad faith and wickedness were required. And this is even before the bailout shenanigans, which has triggered expansion work in some of the lower reaches of Hell.
Here’s a good article on the math involved that doesn’t actually involve any math: http://www.guardian.co.uk/science/2012/feb/12/black-scholes-equation-credit-crunch
Note: I’m not disputing that *some* actions were well-intentioned, just that at each step of the way, lots of people who knew better were complicit – otherwise, it couldn’t have happened.
Of course, many people knew from the get-go that loaning money to people unlikely to pay it back was not a good idea. But by law, it had to be done.