A U.S. Securities and Exchange Commission investigation into credit-rating companies found the firms improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

A 10-month review of Moody’s Investors Service, Standard & Poor’s and Fitch Ratings found analysts contributed to fee discussions and weighed losing clients over certain ratings, the Washington-based SEC said in a report released today. Employees also cast doubt on the quality of some ratings, the SEC said, declining to link firms to specific findings.

“We uncovered serious shortcomings at these firms,” SEC Chairman Christopher Cox said today at a news conference. “When there were not enough staff to do the job right, the firms sometimes cut corners.”

Pension and money-market funds bought AAA-rated securities backed by mortgages to the riskiest borrowers because they offered higher returns than government bonds with the same ratings. In many cases, credit raters were paid by investment banks selling the bonds, prompting regulators and lawmakers to question their independence.

The SEC report describes an e-mail in which an analyst refers to the market for collateralized debt obligations as a “monster.”

“Let’s hope we are all wealthy and retired by the time this house of cards falters,” said the e-mail, which was sent Dec. 15, 2006, to another analyst at the same firm.

Mike Burnick at Sovereign Society says,

A look inside one of these [subprime mortgage] bonds tells a frightening tale. A US$80 billion sub-prime asset-backed bond issued by Deutsche Bank in 2005 is still rated AAA by S&P and Moody’s. Yet, 18% of the mortgage loans in the security are in foreclosure.

Additionally, lenders have already seized 15% of the properties underlying the loan values for this security. Another 10% have been delinquent for more than 90-days.

Another Morgan Stanley Capital sub-prime mortgage-backed security has credit support of 64% relative to the number of delinquent mortgages loans in the pool. But the credit should be at least twice the delinquent mortgages to maintain a top rating.

Why This Junk Isn’t Rated As “Junk”

Technically, much of this so-called triple-A rated debt should have been downgraded long ago. So why hasn’t it? The simple answer is: Fear of too much “collateral damage.”

According to Bloomberg, “Financial firms own high-grade collateralized debt obligations, which package securities such as mortgage bonds and slice them into pieces with varying risk. As the underlying mortgage bonds are downgraded, those securities will also lose their ratings and tumble in value.”

There’s a huge potential “contagion” effect that would ripple through the financial system if Moody’s or Standard and Poor’s dared to downgrade these shaky sub-prime credits across the board. For instance, a bank holding US$100 million of AAA-rated sub-prime bonds needs just US$1.6 million in capital backing such a highly rated credit. – that’s a lot of leverage. And such leverage is fine, as long as the bonds remain triple-A rated.

Should the bonds get downgraded to below investment grade however, under global accounting rules, a bank must put up additional capital. In fact, it would take US$16 million in capital to back US$100 million in non-investment grade bonds.

That’s 10 times as much capital required in the event of a credit ratings downgrade. Wall Street just doesn’t have that kind of extra capital lying around. Bear Stearns found this out the hard way over the weekend. That’s why I expect the major ratings agencies, perhaps abetted by the Treasury Department and the Fed, to continue covering-up the true health of US$650 billion in outstanding sub-prime bonds.

Burnick concludes that:

At the risk of sounding like an alarmist, I just have one question. What happens to confidence in the U.S. financial system (not to mention the dollar) when people wake up and realize these fairy tale markets (held up by fantasy ratings) turn into a nightmare?

The Fed is merely monetizing Wall Street’s mistakes yet again, while leaving future generations of taxpayers with an even bigger tab to settle, and higher future inflation to fight.

But there’s just no time for such ponderings now, we’re in the midst of a full-blown financial crisis after all. Damn the financial torpedoes, full speed ahead with the monetary printing press.

“We need concerted action by governments, central banks and market participants to help stop this wave [of liquidations]…”
- Josef Ackerman, head of Deutsche Bank, speaking in Frankfurt on 17th March

“The government is prepared to do what it takes to maintain the stability of our financial system…”
- US Treasury secretary Hank Paulson to Fox News, March 16th

“In every country in 2008, every government has one aim – to maintain stability through the world economic slowdown. Britain with its central role in the world’s financial system is no exception…”
- UK finance minister Alistair Darling, in his Budget speech of 12th March

Not quite with it yet? Check these examples: it’s already done for you!

“The US tax-payer last week agreed to help J.P. Morgan acquire Bear Stearns after a run on Bear, once the second-biggest underwriter of US mortgage bonds. In an effort to shore up Wall Street’s other firms, you also agreed to become lender of last resort to all 20 primary dealers in Treasury notes…” (Bloomberg)

“US leveraged institutions, which include banks, brokers-dealers, hedge funds and tax-sponsored enterprises, will suffer roughly $460 billion in credit losses after loan loss provisions, Goldman Sachs economists wrote in a research note released late on Monday…” (Reuters)

“The [investment] banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And your money is rushing in to help, with hundreds of billions from the tax payer, and hundreds of billions more from tax-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks…” (Paul Krugman in the NY Times)

With it now? Great fun, isn’t it!

Just cut to the chase about bail-outs and financial aid by remembering what the state’s big generous hand-outs are made from – your tax payments, both current and future, plus the spending power of your savings, ripe for inflating away by elected officials and their unelected agents and staff.

This game beats playing “Spoof” any day, we reckon…which is funny again when you come to think about it.  Because Spoof – played in pubs and bars across the world to decide who buys the next round of drinks – is a game without winners, only a loser. Exactly like this game, then.

Let’s play again

“We need a continuing message from tax payers and cash savers around the world that they will do what it takes to support economic growth. That will not be easy. It may necessitate taking some risks with inflation. But the message has to be unambiguous…”

So said John Varley – or as near as damn it – in a long open letter to government, published by The Banker magazine at the start of this month.

Varley is group chief of Barclays bank here in London. According to the annual report released a couple of weeks ago, he took home £2.4 million last year ($4.8m), just down from his 2006 pay-out of £2.5m after annual group profits fell 1% to £7.08 billion “due to the global financial turmoil” as the BBC puts it.

“The privatization of profit and the socialization of loss”

Don’t get us wrong here; I have no problem – moral or otherwise – with the concept of multi-million-dollar salaries. Executive pay merely puts flesh on those inequities which life itself thrives upon. The profit motive in finance is precisely what created the joint-stock company, mortgage lending, the safety-net of insurance, credit cards, overdrafts and all the other monetary tools developed by homo economicus in the last five hundred years.

But what sticks in the craw, however, is the “privatization of profit [and] the socialization of loss” as Martin Wolf calls it in the Financial Times. Every time the bankers screw up, your money steps in to patch up the losses. Letting the crisis wear on is simply not possible, because no one has dared to try it before.

“The authorities feel compelled to intervene,” writes Charles Kindleberger in his history of Manias, Panics & Crashes. “The dominant argument against the view that panics can be cured by being left alone is that they almost never are left alone.” That’s why we get the pleading from Wall Street and Washington alike today.

Please sir, can I have some more?

“Tax-payers need to continue to supply liquidity,” Varley’s article in The Banker very nearly goes on, “and they can help the restarting of the residential mortgage-backed security and commercial mortgage-backed securities markets by being prepared to accept this paper as collateral.”  More than that, “it would have a significantly (and disproportionately) positive impact if your cash savings were to buy commercial paper.”

Ain’t you brave, gentle reader, stepping into the breach so gamely like this! And so modest, too. Thanks to you covering Wall Street’s losses with your tax-dollars, “we’re going to have maybe a mild recession, but we’re going to avoid anything worse,” reckons Jeremy Siegel, professor of economics at Wharton.

Yet the plaudits will go to somebody else, with nary a murmur from you, reckons Siegel. “[Ben] Bernanke may very well easily turn out to be a hero here,” he explains. Which I guess was precisely your aim in putting money aside to provide for your future.

No redemption without legislation

“Systemically important institutions must pay for any official protection they receive,” Martin Wolf continues for the Financial Times. “Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted.  “This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency. An unregulated, but subsidized, casino will not allocate resources well.”

This quid pro quo – the “this for that” stated so bluntly by Varley at Barclays and Ackerman at Deutsche Bank – is fast-becoming the surest financial consensus in history. If we bail out the banks to stop their stupidity creating a second Great Depression, they must accept far tighter regulation by those governments and bureaucrats who step in to save the day. No redemption without legislation.

There’s always a new way to gear up

Thing is, of course, we’ve all been before. Across the world, hundreds of times. New regulations come in to stall the last crash…and a new complex system of finance sprouts up, thriving on excessive risk which ends up needing your money – your tax receipts and your savings – to mop up the mess when it explodes in turn.

From Barnard’s Act of 1734 – which sought “to prevent the infamous practice of stock-jobbing” that had already peaked and exploded with the South Sea Bubble 14 years earlier – through to Sarbannes-Oxley in 2002, which tried to stop Enron and Worldcom once they had crashed, new standards come in after it matters. Financial risk-taking, meantime, simply moves on to find new ways to gear up, using the latest regulations to pin-point those loopholes that will, in due course, be closed up when it no longer counts.

Just what were the FSA thinking? Or were they not thinking at all?

“After the collapse of Equitable Life in 2000,” notes a letter to The Times of London last week, “the Financial Services Authority [UK watchdog] set up a review team on the regulation of the assurance society. Among the important ‘lessons to be learnt’, identified in 2001 were – and I quote verbatim – that ‘the FSA management take steps to ensure that the supervisory team is properly constituted with persons with the necessary expertise and knowledge…. “

[Yet] from the recent internal audit by the FSA on its regulation of Northern Rock [the top 5 mortgage lender which blew up in Sept. 2007] we learn that the bank ‘was monitored by supervisors with expertise in insurance, not banking’…”

More than that, the FSA failed to conduct a proper review of Northern Rock’s operations for the entire 18-month period leading up to its collapse. Even then, prior to that last full review of Feb. 2006 – and “contrary to standard practice” as this week’s official report into the scandal revealed – “formal records of key meetings were not prepared.”

Thus the quid pro quo of bail-outs for new rules becomes, in the end, a straight swap of excessive risk for incompetence. Underpinning this long-run historical fact you’ll find the assumption that “if one cannot control expansion of credit in boom, one should at least try to halt contraction of credit in crisis,” as Charles Kindleberger concludes.

For you, the tax-payer and saver, all that means is you get to pay twice – first in higher deductions and then through inflation.

Bet you’re glad Ben Bernanke will get all the thanks.