rating the rating agencies

• No one suggests that the big three credit-rating agencies, Standard & Poor’s (S&P), Moody’s and Fitch, did a good job evaluating mortgage-backed securities before the financial crisis. Whether their shortcomings were also criminal is set to become clearer after this week’s decision by the Department of Justice to charge S&P with fraud.
• A complaint filed in a Los Angeles federal court charged S&P with intentionally making “limited, adjusted and delayed updates” to its rating criteria and analytical models during a key period stretching from 2004 and 2007. This foot dragging, the complaint alleges, led to overly favourable ratings for structured debt securities, which in turn produced massive losses for those investors who bought the highest-rated securities, and in particular for the Western Federal Corporate Credit Union (WesCorp), which ultimately failed.
• The use of Los Angeles-based WesCorp in the complaint allowed the case to be filed in an unusual jurisdiction for a financial crime, but one the Justice Department doubtless believes is helpful to its cause. The case also enables the department to attempt a novel use of a law, the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), which was passed in 1989 after the savings-and-loan crisis. Previous attempts to sue ratings agencies for their boom-era practices have foundered in part because of a long-standing argument that their opinions are protected by the First Amendment of the constitution, which states that “Congress shall make no law…abridging the freedom of speech.” The government’s case under FIRREA is for civil fraud, however, and therefore sits outside the amendment’s protection.
• News of the charges unsettled investors. The share price of McGraw-Hill, S&P’s parent, dropped by 16% when news of the charges emerged on February 4th, and fell by another 10% the next day. Shares in Moody’s fell almost as steeply.
• The 119-page complaint was filled with the usual excruciating excerpts from internal correspondence. In one, an “executive H” accused S&P of pandering to the opinions of underwriters and issuers out of concern that a tougher approach, however justified, might send business to more lenient raters. In another, an analyst circulated a parody of a Talking Heads song, “Burning Down the House”, that was based on the weakness of the housing market. The analyst later sent a video of himself performing the song to laughing colleagues.
• S&P’s reaction to the charges was unequivocal. It vowed to fight and, in a press release, said that comments in the complaint had been “cherry-picked” and taken out of context during a period when there had been “robust” internal debates about deterioration in the housing market. As the complaint itself makes clear, there had also been serious debate about how to evaluate securities in a fast-growing but complex area. All of the securities in question had received identical ratings from another agency, S&P noted, suggesting its opinions reflected a broad consensus.
• Missing entirely from the Justice Department’s complaint is any sense of the responsibility borne by the entities that purchased the wrongly rated securities. WesCorp, for example, was a particularly odd institution, a credit union for other credit unions that had been extremely gung-ho about housing. It collapsed amid accusations of pervasive mismanagement. Other “victims” of S&P ratings that were cited in the federal complaint include Citibank and Bank of America. And a series of follow-up lawsuits this week included one from California’s state attorney-general on behalf of CalPERS and CalSTRS, two vast pension funds.
• Implicit in such suits is the premise that even the largest institutions lack the ability, or even the obligation, to do independent credit evaluations. The Justice Department has decided to put S&P in the dock. Inevitably, it will put investors on trial as well.