Justice Sues S&P; Is It Time to Rethink the Role of Ratings Agencies?

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Scott Eells / Bloomberg / Getty Images

Standard & Poor's headquarters in New York, Feb. 5, 2013.

Most of the time, court cases are manna for journalists. The politicians and corporations we cover aren’t in the habit of dishing out information they don’t want the public to know. But along comes a lawsuit, and the parties are often forced to put a lot of juicy details on the public record. So when the Justice Department yesterday announced a joint federal and state lawsuit against the ratings agency Standard & Poor’s for defrauding investors in the run up to the financial crisis with its overly optimistic ratings of mortgage-related investments, I was excited to see what new dirt the complaint would unearth.

Much to my chagrin, however, the complaint is a fairly mundane read  for the simple fact that we have known for years that the ratings agencies were hamstrung by a fundamental conflict of interest: They are paid by the sellers of securities rather than the buyers. So during the inflation of the real estate bubble in the early 2000s, as investment banks scrambled to package mortgages into complex financial instruments, ratings agencies also scrambled to figure out how to get those investment banks to chose them to rate their securities. What was S&P’s strategy to entice investment banks to pay it rather than its competitors? Rate their securities higher.

The complaint does put this dynamic into sharper relief, as it provides us with the details of conversations, emails, and instant message exchanges that show the evolution of S&P’s ratings philosophy from one focused primarily on accurate analysis to one focused on pleasing issuers who paid it large fees.

(MORE: The S&P Soars, the Economy Snores)

Of course, this conflict of interest was well documented in the immediate aftermath of the bursting of the real estate bubble and even before the financial panic of 2008. A 2011 report from the Senate Permanent Subcommittee on Investigations named rating agency failure as a contributing factor to the financial crisis. Reads the report:

Because credit rating agencies issue ratings to issuers and investment banks who bring them business, they are subject to an inherent conflict of interest that can create pressure on the credit rating agencies to issue favorable ratings to attract business. The issuers and investment banks engage in “ratings shopping,” choosing the credit rating agency that offers the highest ratings. Ratings shopping weakens rating standards as the rating agencies who provide the most favorable ratings win more business.

And long before the financial crisis, the idea that the ratings agencies were beholden to issuers rather than investors was in the air. These firms were criticized for waiting too long in the midst of the Enron scandal to downgrade the firms debt. In fact, ratings agencies have been coming under fire as far back as the New York City debt crisis of the 1970s for failing to alert investors to the true creditworthiness of certain issuers.

So this case does raise the question of why the feds are only now cracking down on S&P. Does it really take six years to put a case together, when it was all but certain that this sort of misleading behavior was rampant in the run up to the crisis? Furthermore, why are we not seeing action against Moody’s and Fitch, the other two major ratings firms? And perhaps most importantly, this case should have everyone asking: Just what purpose do these ratings agencies serve?

In the equities business, you have “sell-side” analysts who are directly employed by large investment banks and brokerages, and their opinions are taken with the appropriate grain of salt, just as you may only reluctantly trust glowing reviews of the newest model from your local car dealer. But in debt markets, things are different. Issuers pay independent ratings agencies to tell investors how credit worthy they are. How did it become that the debt market developed in this way?

(MORE: Why the S&P 500 Is Defying Economic Reality)

Frank Portnoy, a professor of law and finance at the San Diego School of Law published an influential paper in 1999 which addressed this question. He argued that beginning in the 1930s, the regulatory system of the federal government began to incorporate ratings agencies’ reports into its rulemaking process. For instance, the SEC relied on ratings agencies to help value capital set aside by broker dealers. And in 1973, the SEC doubled down on this approach, designating certain rating’s firms “Nationally Recognized Statistical Ratings Organizations.” Predictably enough, it was right around this time that the ratings agencies shifted their business models from charging investors fees for their reports, to charging issuers for being rated.

In other words, when the government designates certain companies the official arbiters of creditworthiness, those firms are going to capitalize on that special power. They can, in effect, say “If you’re not rated by me, you can’t participate in American capital markets.”

As part of the Dodd-Frank financial reform, the SEC was given broader powers to monitor and crack down on conflicts of interest at the ratings agencies. The law also requires regulators to remove references to ratings from their own regulations when those ratings are used to assess the creditworthiness of a security or money market instrument. But hurdles still remain. International banking regulations still make use of ratings firms analysis, so when implementing those rules at home, regulators will have to be creative.

But if Portnoy is right, and these ratings agencies have stuck around mostly because of the regulatory role bestowed upon them, we may be seeing the beginning of these firms’ obsolescence. And that may be a good thing. After all, markets work best when investors do their own due diligence. And if a product — like these complex mortgage-backed investments — are too complicated for an investor to evaluate on his own, he probably shouldn’t be investing in it in the first place.

6 comments
NG
NG

The bad qualifications of the S&P managers is well known. The majority of them would have difficulty finding a job waiting tables! The malfeasance at this firm is mind boggling, as seen in several lawsuits by former employees against S&P. Shame on S&P! Shame on  McGraw-Hill!

NG
NG

Justice at last. S&P's dishonesty is well known to all and their credibility is already shot. Worse, anyone who complained about their practices was immediately retaliated against. Bad management has been the hallmark of this firm and it is a pity the the new CEO did nothing about this. But hey, as Upton Sinclair said:  "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"

Ocsicnarf
Ocsicnarf

And auditors? What do you tell me about them? People paid to check by the same people they check.

KountyKobbler
KountyKobbler like.author.displayName 1 Like

The S&P  are supposed to be Honest guides to the safety of an investment  or  the giudance of how safe  you are in inavesting in  a bet for income.   and  when thier word was not worth  your investmet thieir advice is worth Nill  and  you can not trust thier values   so you have someone to blame for your living on the street  when you had had millions.. 

my4sons
my4sons

False sense of security is the purpose and money for puppeteering.