United States v. Standard & Poor's

February 5, 2013



United States v. Standard & Poor's

By R Tamara de Silva

January 5, 2013

       The Department of Justice filed a civil lawsuit yesterday against one of the of big three credit ratings agencies, Standard & Poor's ("S&P") and its parent company, McGraw-Hill, Inc.[1]  The suit alleges that S&P deliberately gave its coveted triple-A ratings to sub-prime debt in order to win fees.  The suit does not address the structural conflicts of interest within the three credit ratings agencies that are Nationally Recognized Statistical Rating Organizations ("NSRO"), nor will it address or cure any of the underlying causes of the credit crisis.  While there are problems with the credit rating agency business model, it will be difficult to prove that S&P knew any more than even the audit committees of the investment firms on whom it relied, or the issuers of debt instruments themselves.  The suit will of course result in the levy of a fine.  But while S&P's hands may not be entirely unsullied- far more importantly to the untrained public eye, they are as good a scapegoat as any other.

       S&P is a credit rating agency whose business is to provide credit ratings represented by letters from triple-A to D, in exchange for fees.  Federal laws require that certain institutions only hold investments that have a credit rating of "investment grade," but most of the financial world relies on credit ratings agencies to weigh and measure risk, risk defined in terms of the credit worthiness of investments and institutions.    S&P is the largest of three credit ratings agencies that is recognized by the Securities and Exchange Commission ("SEC") as an NSRO.   From 2004 towards the end of 2008, S&P assigned credit ratings on nearly $4 trillion of debt instruments.  In terms of sheer size and credibility, despite this suit and skepticism of the NSROs particularly in Europe, the world has no credible alternative to credit ratings agencies and specifically nothing to replace, Standard & Poors.

       Keep in mind that almost five years after the worst financial crisis in United States history, the Department of Justice has yet to criminally charge a single culpable senior executive or firm.  If history is any guide, the Justice Department will reach a civil settlement with S&P wherein the firm will agree, without admitting any wrongdoing, to pay a fine that in relative terms, will have as large a fiscal impact on S&P as the cost of one month's dry kibble would have to the owners of the Grumpy Cat.  The suit asks for a fine in excess of $1 billion but these will typically be negotiated down and the government has not latterly demonstrated a willingness to go to trial with these suits.  Like so many Wall Street settlements reached over the past ten years, the cost of the settlement fine imposed will ultimately be a pittance relative to the quarterly earnings of the offending firm-S&P is not likely to become the first exception to this rule.

       There in the gilded annals of academic and economic theory yet remains the tidy axiom that markets are self-correcting.  It is thought that market forces of supply and demand will drive out weaker competitors and bring in new ones through their own determinative natural selection.  It is not necessarily so.  Yet this assumption is an inescapable cliché of economic theory now unfortunately embedded into political discourse.  This axiom ignores the asymmetrical political and economic power of some market participants relative to others, and the use of regulation to give some participants a structural competitive advantage over others.  Self-correcting economic behavior occurs famously in the instance of market bubbles like tulip manias, Internet stocks and real estate bubbles, all of which eventually burst.   However, none of this bursting applies to credit ratings agencies. 

       Credit ratings agencies are often wrong, have been wrong and will not, even under Dodd-Frank, need to be correct, much less try harder to do so, or for that matter make any effort towards attempting to.   All three credit ratings agencies adjusted their triple-A ratings of debt instruments to less than investment grade at virtually the same time the rest of the world figured out there was a problem with them.  In their defense, S&P points out that credit ratings are, "forward-looking opinions about credit risk. Standard & Poor's credit ratings express the agency's opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time." [2]  The problem is that by the time the credit ratings agencies, self-correct, their statements are no longer forward looking or even present looking but much more akin to being told how a movie ends a few months after you have seen it.

       Not that long ago, collateralized debt obligations were repackaged during the credit bubble into investment pools and other mortgage backed securities and collectively adorned with the gold standard of financial ratings, the coveted AAA ratings of the largest credit ratings agencies, Fitch, S&P and Moody's.   The credit ratings agencies gave their coveted and in theory elusive triple-A rating to investments that were anything but credit worthy or in the best case, possessed of a very mixed credit pedigree.  The agencies' bestowal of triple-A ratings to companies and investment vehicles that were junk and later discovered to be junk, caused losses in the billions and trillions of dollars to everyone who relied on their ratings--essentially everyone.

       The role of the credit ratings agencies, was present from Goldman Sachs' knowingly selling instruments it bet against in Abacus to Citigroup's selling of investments it also bet against-all these transactions of a seemingly knowing fraud were adorned with triple-A ratings.  Triple-A ratings played an essential role in the credit crisis- enough to make them arguably the largest "but-for" causal culprit of the financial crisis.  "But for" the credit ratings agencies bestowal of triple-A ratings on sub-prime debt investments, the credit crisis would not have occurred.   But the financial world does not operate as simply as the liability model used by personal injury lawyers to make someone pay for car accidents or anything resulting in a personal injury.  The financial world is incomparably more complex and the causes of the financial crisis are many.

       In a larger sense, the credit ratings agencies cannot help it.  The fault lies with their business model and that having no competition, they really can be wrong in the largest possible way and not be "wrong" in the conventional sense. 

       The big three credit ratings agencies are bestowed with a monopoly by the government and if the world did not like the big three credit ratings agencies, it would find (with the exception of a few marginal players) that it had precisely nowhere else to go.  Put another away, even after having the SEC accuse them of consumer fraud, and being about as wrong as they can be, the big three credit ratings agencies still rate 96% of the world's bonds.  Sort of as Henry Ford was reputed to have said about offering customers the choice of a new model T in "any color so long as its black."

       What is more, their business model makes the ratings agencies operate within a closed conflict of interest loop.  The credit ratings agencies are paid by the issuers (who are also their clients) of the securities they were supposed to evaluate-this creates a conflict of interest.

       But the government, or specifically the SEC knew of the conflicts of interest within the credit rating agency business model and approved of them.  In June 2007, the SEC acknowledged that there might be a real problem having the referee in a match being paid by one of the sides-not the investors or the public's side either.   The SEC asked S&P for documentation of how S&P handled conflicts of interests and after several months of scrutiny, approved of S&P as a NSRO--again, after having vetted the inherent conflicts of interest within S&P's business model. 

       The ratings agencies have lobbying power in Washington and every interest in protecting their triopoly, which remains, even after the Credit Crisis and the implementation of Dodd-Frank, wholly unscathed.  But really, in the absence of any alternative and near total dependency, the world has an interest in S&P too.

       The most persuasive mitigating factor against charging the S&P or any of the credit ratings agencies with fraud is that they themselves relied on the internal audit committees of their clients/issuers.  The credit ratings agencies relied on the audit committees of their issuer clients, which committees had signed off and attested to the S&P and the other credit ratings agencies about the value and risk profiles of the investments for which they sought ratings.  Ultimately, unless corporate boards are compromised of crony Chia pets distinctly and wholly incapable of bearing any liability or culpability (a very real possibility upon even a cursory scrutiny- and another discussion for another time), they ought to bear the responsibility for misleading the credit ratings agencies, or simply not knowing what they were doing.

       Either the investment banks' audit committees were not qualified to pass on these investments or the credit ratings agencies were not.  What now seems obvious is that both the credit ratings agencies and the audit committees were not sophisticated enough to understand the investment products they were charged with scrutinizing.  They approved of them anyway.  

       The credit ratings agencies could not give accurate ratings of many of the instruments involved in the housing bubble and credit crisis because of the complexity of the transactions involved and their inability to understand what they were analyzing.  Not knowing what they were doing makes them at least guilty, if they were regular market participants, (which they are not) of criminal fraud.   They may have culpability because they perpetuated a fraud on the marketplace by accepting money and using their position of trust, as a government sanctioned arbiter or investments, to pretend to pass on investments when in reality they did not know what they were examining or did and had a financial incentive to lie.  One thing is certain, were the credit ratings agencies like any number of the two-bit individuals the Department of Justice and SEC have prosecuted, one could say that the prosecution of fraud is not disproportionately tilted towards the smallest financial participants, or at least squarely away from the largest ones.

       In theory, the credit ratings agencies exist to level asymmetries of information.  They are also supposed to evaluate risk.   Unfortunately, the credit ratings agencies have conflicts of interests and they evaluate financial products (like collateralized debt obligations) that they do not understand.  They were far from alone in not understanding the debt instruments presented to them.  In 2007, even Ben Bernanke thought the risk of sub-prime debt was contained.  The ratings agencies, like most of Wall Street during financial crises seemed to lack fixed ways to measure absolute risk, and as a result during financial crises, when you would most want risk models to work, they too prove catastrophically wrong.  Moreover, as much as Wall Street was wrong in assessing its risk, so was the government and many of Wall Street's largest institutions-so why merely pick on S&P?  Unlike all of the players on Wall Street however, the credit ratings agencies are still the only game in town.  The Department of Justice's civil suit will do nothing to change this.@

R Tamara de Silva

Chicago, Illinois

[2] http://www.standardandpoors.com/ratings/definitions-and-faqs/en/us