The credit rating agency Standard & Poor’s has just confirmed that the US Justice Department will bring a civil action against it claiming that model used to rate mortgage-backed securities was inadequate. The Justice Department claims that inflated ratings of securities directly contributed to the housing bubble and in turn the financial crash.
Commentators have been pondering the question of why S&P is the only agency to face a law suit, and why now. Many have been swift to point to the fact that S&P has been the only CRA to date to downgrade the US, lowering the rating to AA+ with a negative outlook in August 2011. Whether this theory holds any water, I suspect we will never know, however if this is successful it is almost certain that other suits will follow (if parties don't settle first). On news of the action, shares in S&P’s parent company, McGraw Hill, fell 13.8%, the largest one day fall since the stock market crash of 1987. Shares in Moody’s were also down 10.7%, as investors anticipate a ripple effect throughout the ratings industry if the action is brought.
The case could signal a change of approach to the rating agencies, which have so far remained untouchable, shielding themselves (in the US at least) by the First Amendment to the Constitution under which ratings are deemed to be “opinions”, protected as free speech. However, the civil action threatened by the Justice Department has a lower burden of proof than previous criminal prosecutions.
Negotiations between the US Justice Department and the CRA broke down when the Department demanded a settlement of $1 billion from the agency. S&P state the action is “without legal merit and unjustified”, and in a statement lists the steps taken by the agency to enhance systems, governance, analytics and methodologies since 2007. The page of the agency’s website explaining changes brought in by the company also highlights a handy link to a plain-English explanation of what ratings are, and what they are not, in case there was any doubt still. The statement by the agency stresses that ratings were provided in good faith by S&P in the "unprecedented" housing market of 2007. It points out that collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBSs) that were awarded AAA ratings also received similar ratings from rival firms.
It states that the Department of Justice’s plan to use the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 would be unprecedented, and would have no legal merit.
Consequently, despite the fact that the agency “deeply regrets” that it failed to anticipate the extent of the downturn in the market, it claims that this was not foreseeable, and that when doubts were raised, the agency took immediate action to reassess the relevant ratings.
The proposed action has reignited debate over the best ways to effectively regulate CRAs. Due to their position as gatekeepers to the markets, both for private issuers and sovereign states, agencies hold a great deal of power within the markets. Owing to the current way in which ratings are requested, paid for and issued, numerous conflicts of interest have been highlighted, many of which have been discussed in earlier posts. The possibility cited above of a previous downgrade being the reason for the current action stresses even further the inter-dependency of nation states and CRAs when dealing with access to international markets and international regulation. The fact that this action could represent any kind of "pay back" on the part of the US Department of Justice and Securities and Exchange Commission (SEC) is a frightening prospect. Issues that are this important for the security and stability of the economy must remain above the "tit for tat" of politics and retribution.
Since the financial crash, CRAs have responded by separating braches of their operations and repeating that ratings are assigned in good faith. Regardless of regulation, however, the issue remains that the job of assessing risk and assigning a rating to a debt has to be performed. It provides a quick source of information that remains vital to the markets, despite claims by the agencies that investors should rely on their own research rather than simply a rating. As CRAs have come to occupy such positions of power within the markets, it seems likely they will continue to fulfil this role. Questions of effective regulation that deal with conflicts of interest, therefore, will continue to occupy policy makers, market leaders and academics for some time to come.