Justice Department investigating S&P

August 17, 2011 · Posted in News and Current Affairs, Political News, Wall Street vs Main Street 

The junk mortgage kings?

The New York Times is reporting that the Justice Department is investigating Standard and Poors over their actions before the mortgage meltdown.

The Times reports the investigation began before S&P did its controversial, math-challenged downgrade of the U.S. credit rating.

From the Times story:

The investigation began before Standard & Poor’s cut the United States’ AAA credit rating this month, but it is likely to add fuel to the political firestorm that has surrounded that action. Lawmakers and some administration officials have since questioned the agency’s secretive process, its credibility and the competence of its analysts, claiming to have found an error in its debt calculations.

In the mortgage inquiry, the Justice Department has been asking about instances in which the company’s analysts wanted to award lower ratings on mortgage bonds but may have been overruled by other S.& P. business managers, according to the people with knowledge of the interviews. If the government finds enough evidence to support such a case, which is likely to be a civil case, it could undercut S.& P.’s longstanding claim that its analysts act independently from business concerns.

It is unclear if the Justice Department investigation involves the other two ratings agencies, Moody’s and Fitch, or only S.& P.

During the boom years, S.& P. and other ratings agencies reaped record profits as they bestowed their highest ratings on bundles of troubled mortgage loans, which made the mortgages appear less risky and thus more valuable. They failed to anticipate the deterioration that would come in the housing market and devastate the financial system.

Since the crisis, the agencies’ business practices and models have been criticized from many corners, including in Congressional hearings and reports that have raised questions about whether independent analysis was corrupted by the drive for profits.

The Securities and Exchange Commission has also been investigating possible wrongdoing at S.& P., according to a person interviewed on that matter, and may be looking at the other two major agencies, Moody’s and Fitch Ratings.

In an unrelated note, Fitch downgraded Chris Christie’s New Jersey today … sorry, Karl Rove.

Part of the issue with the ratings agencies is that they are for-profit entities, not independent agencies. In S&P’s case, they are a division of McGraw Hill (that, of the Bush-friendly McGraws…)

The right will surely cry bloody murder and political bullying over the investigation by their nemesis at Justice, Eric Holder. But the real question should be whether the downgrade happened in part because of the investigation, which after all, was under way first.

And why should Americans trust these agencies, which are essentially the TransUnion and Experian of corporate rating — wholly private, and in some cases, paid to give banks good marks. This from that Times story:

“I think it would have a major impact if there was a successful fraud case that would suggest there would be momentum for legislation that would force them to change their business model,” said Richard Sylla, a professor at New York University’s Stern School of Business who has studied the history of ratings firms.

In particular, Professor Sylla said that the ratings agencies could be forced to stop making their money off the entities they rate and instead charge investors who use the ratings. The current business model, critics say, is riddled with conflicts of interest, since ratings agencies might make their grades more positive to please their customers.

Before the financial crisis, banks shopped around to make sure rating agencies would award favorable ratings before agreeing to work with them. These banks paid upward of $100,000 for ratings on mortgage bond deals, according to the Financial Crisis Inquiry Commission, and several hundreds of thousands of dollars for the more complex structures known as collateralized debt obligations.

Ratings experts also said that a successful case could hamper the agencies’ ability to argue that they were not liable for ratings that turned out to be wrong.

“Their story is that they should be protected by full First Amendment protections, and that would be harder to make in the public arena, in Congress and in the courts,” said Lawrence J. White, another professor at New York University’s Stern School of Business, who has testified alongside ratings executives before Congress. “If they mixed business and the ratings, it would certainly make their story harder to tell.”

And the bottom line is, the agencies are simply not trustworthy. From Yale Gloobal:

Never before in history have so few people held the fate of the global economy in their hands. Not the giants of Wall Street, but three small private companies – the top credit-rating agencies – have emerged as the arbiters of the world’s economic fate. As politicians huddle in Washington and Brussels, debating a way out of the US and eurozone debt crisis, businesses around the world keep their eyes peeled on the rating agencies’ decision to grade the sovereign debt issued by governments. Lowering the AAA grade by just one point could trigger a flight from bonds with cascading consequences throughout the economy.

One can’t help but wonder how the governance of global finance shifted to these agencies. After all, these same agencies awarded AAA ratings to toxic bonds that imploded in 2008.

Ever since liberalization of banking rules and freeing of capital movements in the 1980s, the power of the “big three” – Standard & Poor’s, Moody’s and Fitch – has grown. The issuers who intend to sell bonds or other forms of debt – usually companies, but also countries, NGOs or special-purpose vehicles – pay the credit agencies to rate the bonds when first issued and afterwards. Although there are other ratings agencies, these three have legal standing in the US where many fund managers use the ratings to select “investment grade” debt that offers good chance of repayment.

Read the whole post, by Tufts University professor David Dapice. Depice gives a history of the agencies and their growing influence. And he reminds us of this:

The agencies failed miserably, some argue with willful ignorance, in rating many mortgage-backed securities, and this played a role in bringing about the global financial crisis. The finance industry shouldn’t have been too surprised, after the same firms failed to downgrade Enron’s debt until a few days before it went bankrupt in 2001, of little value for investors. Failing to foresee the complexity and low quality of many mortgage-backed securities, rating highly dubious mortgages contained in complicated packages as AAA or the highest quality, the agencies gave investors a false impression of safety. For some critics, the lack of due diligence suggested more of an interest in getting paid than in accurately researching the securities.

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Comments

One Response to “Justice Department investigating S&P”

  1. Ronbo on August 21st, 2011 7:48 pm

    Yes! Unfortunately, if history is a guide, they will investigate something totally unrelated and find (viola!) nothing illegal. This way S&P can claim that they have been investigated and found innocent of all charges.

    We’ve seen this time after time. It’s an old trick to give cover to corruption.

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