Over the past two weeks the credit rating agency Standard and Poor’s (S&P) has come close to finalizing settlements with both the Securities Exchange Commission (SEC) and the Department of Justice (DoJ) over pending litigation.1
In the wake of the 2008 financial crisis, the government, the public, and regulators across the country have pointed their fingers at as many would-be culprits as possible, including credit rating agencies. Among these is Standard & Poor’s, who, along with Moody’s, is one of the two largest credit rating agencies in the country.2 S&P rates private and public debt on a scale from AAA to D, taking into account factors such creditworthiness and risk of default.3 And it was in rating such debt, subprime mortgage backed securities in particular, that has S&P in trouble today.
The SEC’s case is based on alleged fraudulent methodologies used by S&P in 2011 in rating a portfolio of commercial mortgage-backed securities put together by Goldman Sachs and Citigroup as well as failures for internal controls and risk management.4 The SEC contends that S&P brushed aside an employee’s call to use stricter rating standards instead of standards advantageous to bond issuers.5
Around the same time, the DoJ filed suit against S&P alleging misrepresentations involving their ratings of bonds, mostly mortgage-backed securities, before the crisis.6 These alleged misrepresentations inflated the rating status of certain bonds, harming investors in favor of S&P and issuers.7 This harm to investors is the other prong of the DoJ’s argument – that S&P had to protect investors by warning them of rating misrepresentations and the impending housing crisis.
These suits raise the dual questions of whether the settlements really matter and why regulatory actions weren’t taken sooner. The suits are an important first step in reining in an otherwise overlooked aspect of the financial market, particularly because they are the first actions ever taken by the SEC against a top credit rating agency.8 The penalties are also enormous, not just in a strict dollar amount, but also because being suspended from rating in the commercial mortgage-backed securities market will likely cause S&P to lose out on future business and lose its place as one of the top two ratings agencies, particularly with the emergence of Kroll Bond Rating Agency.9 Further, it may continue to erode not just the credibility of S&P’s credit rating capacity, but also that of all credit rating agencies.10
Despite such drawbacks to S&P, things may not be so dire. Throughout these suits, demand for S&P’s services has increased, as have their revenues – there does not appear to be a lack of confidence.11 And even if confidence eroded, unless other suits arise there will always be other credit rating agencies ready to pounce on the business that S&P does not get.
Attempts have repeatedly been made by regulators to restrain, or even eliminate, credit rating agencies, but they have not worked. To comply with Basel III capital rating standards, regulators considered eliminating rating agencies but were unable to find a suitable replacement.12 Regulators have also tried to limit investor reliance on rating symbiology (such as AAA), in particular, through differentiating rating symbols between corporate debt and collateralized securities which have very different risk and default profiles. Again, this change was not made. Instead, the Dodd Frank Act has made small efforts to curb the power and influence of rating agencies, such as changing liability standards, giving the SEC more power to regulate and punish, and disclosing rating shopping.13
Despite S&P’s recent legal struggles, rating agencies are here to stay. By settling, S&P neither had to admit nor deny any type of wrongdoing, thereby limiting the damage to its reputation. And while the SEC and DoJ may be taking a harder stance against potential credit rating agency fraud, these agencies have escaped the brunt of political and regulatory force levied against them.
Paul Barrett, S&P’s Settlement With The SEC Isn’t The End of Its Problems, Bloomberg Business (Jan. 20, 2015) http://www.bloomberg.com/news/articles/2015-01-20/s-p-s-settlement-with-the-sec-isn-t-the-end-of-its-problems. ↩
Rebecca Marston, What is a Rating Agency?, BBC News (Oct. 20, 2014) http://www.bbc.com/news/10108284. ↩
Id. For a more in depth discussion of credit rating, particularly with collateralized debt and loan obligations, see Efraim Benmelech & Jennifer Dlugosz, The Alchemy of CDO Credit Ratings (2009). ↩
Ben Protess & Matthew Goldstein, S&P to Pay Nearly $80 Million to Settle Fraud Case, The new York Times, (Jan. 21, 2015) http://dealbook.nytimes.com/2015/01/21/s-p-to-pay-nearly-80-million-in-settlements. ↩
Matt Robinson, S&P Unit Said Nearing Suspension Was at Heart of Internal Battle, Bloomberg News Enterprise (Jan. 20, 2015) http://www.bloomberg.com/news/articles/2015-01-20/s-p-unit-said-nearing-suspension-was-at-heart-of-infight. ↩
Barrett, supra note 1. ↩
Protess & Goldstein, supra note 4. ↩
Barrett, supra note 1. ↩
Gretchen Morgenson, The Stone Unturned: Credit Ratings, The new York Times (Mar. 22, 2014) http://www.nytimes.com/2014/03/23/business/the-stone-unturned-credit-ratings.html. ↩
Earnings, McGraw Hill http://investor.mhfi.com/phoenix.zhtml?c=96562&p=irol-newsearnings. ↩
Dave Clark, Regulators Propose Credit Rating Alternatives, Reuters (Dec. 7, 2011) http://www.reuters.com/article/2011/12/07/us-financial-regulation-fdic-idUSTRE7B61IG20111207. ↩
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203 §933 and 939, 124 Stat. 1376 (2010). ↩
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