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Editorial: Ratings War; Government Targets S&P

It is perhaps appropriate that last week’s big snowstorm partially buried news of the lawsuit filed by the federal government against Standard & Poor’s, the nation’s largest credit ratings agency. If what the Justice Department alleges is true, S&P engaged in a monumental snow job from which the nation’s economy is still digging out four years later.

The government asserts that S&P executed a scheme to defraud investors by assigning inflated ratings to securities created from bundles of subprime mortgage loans, thus misrepresenting the true credit risks. The Justice Department is seeking $5 billion from S&P and its parent company, the amount it says federally insured financial institutions suffered in losses from the inflated ratings.

Why would S&P do such a thing? You will perhaps be shocked to learn that the government’s answer is “money.” The three major ratings agencies are generally paid by the issuers of the securities they rate. In this case, S&P was paid about $13 million in fees to rate 40 collateralized debt obligations that banks had packaged into bundles of mortgage bonds, which in turn were composed of individual home loans. The lawsuit alleges that while S&P professed that the ratings were objective and not influenced by its relationships with investment banks, in fact its desire for more revenue and bigger market share led it to favor the interests of the banks over those of investors, even as the market was coming apart.

In one internal 2007 email cited by the government to support its claim that the ratings service was aware of the problem, an S&P analyst invoked the Talking Heads’ Burning Down the House in referring to the deteriorating market: “Subprime is boiling o-ver. Bringing down the house.”

For its part, S&P says the suit is “without factual or legal merit,” adding that its competitors gave the same ratings to the securities. More interesting is the claim that nobody else saw the meltdown coming either, including government agencies, financial institutions or other experts. “Unfortunately,” the company said, “S&P, like everyone else, did not predict the speed and severity of the coming crisis and how credit quality would ultimately be affected.” Floyd Abrams, a lawyer representing S&P, put it this way: “S&P believed what it said. Period.”

That period is followed by a question mark in our minds. Is it not the role of S&P and the other ratings services precisely to sniff out potential weakness when market, government or other expert opinion is blind to it? It almost sounds as if the alternate explanation to fraudulent conduct is incompetence. As Michael Lewis made clear in The Big Short, the worthlessness of the bundled mortgage bonds that received top ratings from S&P and other agencies was recognized by a handful of investors who did what S&P was supposed to: examine them with enough rigor to actually assess their value.

If the American public learned anything from the near-collapse of the financial system, it is that whatever ills infect Wall Street are highly contagious on Main Street. After four years, the national economy is still recovering slowly and employment has a long way to go yet. And while the Justice Department’s suit, if successful, may punish past conduct, we wonder if it does enough to correct what is inherently a flawed system. Ratings agencies should not be paid by the institutions whose securities they rate. The incentives are all wrong. Their fees should be paid by institutional investors, or else these ratings services should report to government regulatory bodies, or even become a branch of government.