The U.S. government charged Standard & Poor's Ratings Services with misleading investors about the quality of mortgage-backed investments in the run-up to the financial crisis.
The U.S. government charged Standard & Poor’s Ratings Services with misleading investors about the quality of mortgage-backed investments in the run-up to the financial crisis.
It is the government’s first big enforcement action related to a credit rating agency’s actions before the 2008 crisis. S&P said it would vigorously defend itself against charges that it deemed “meritless.”
So what’s the big deal? And what did the bond-analysis shops have to do with the financial crisis?
Here are some questions and answers about the charges against Standard & Poor’s:
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Q: The government brings civil charges against financial companies all the time. What’s so important about this case?
A: These are the first federal charges against one of the credit rating agencies that are widely blamed for contributing to the financial crisis that brought about the worst recession since the Great Depression.
They appear to signal a new, tougher direction for the Justice Department, which has faced years of criticism for failing to punish those responsible for the crisis.
The crisis crested when a bubble in U.S. home prices popped, making it more difficult for people to refinance their mortgages and setting off a wave of defaults and foreclosures.
Wall Street banks had created trillions of dollars’ worth of investments whose value was based on what those mortgages were worth. The investments were spread through the financial system. Without rating agencies, none of that would have been possible.
Q: If they didn’t create or sell the investments, why are credit rating agencies blamed for their proliferation?
A: Agencies like Standard & Poor’s gave high ratings to complex pools of mortgages and other debt. That gave even risk-averse buyers the confidence to own them. Some investors, including pension funds, can only buy securities that carry a high rating. In short, credit ratings provided by S&P greased the assembly line that allowed banks to push risky mortgage bonds out the door.
When they realized the bonds were worth far less than previously thought, in late 2007, Standard & Poor’s and other agencies lowered the ratings on nearly $2 trillion in mortgage securities. The downgrades helped spread panic because holders of the bonds and any potential buyers of them no longer knew their value.
The government says S&P knew the bonds were risky, but gave them artificially high ratings in a quest for higher revenue and greater market share.
Q: Why would they give ultra-safe ratings to risky mortgages?
A: The government sided with critics of the industry, who believe it suffers from a fundamental conflict of interest: Rating agencies are paid by the same companies whose bonds they rate.
According the lawsuit, S&P held off on downgrading mortgage investments because it feared upsetting customers, who could easily take their business to another agency.
S&P competed with Fitch and Moody’s for the business of the banks and brokerages that were packaging the mortgage-backed bonds. In some cases, critics say, rating-agency analysts were pressured to give unrealistically high ratings to curry favor with Wall Street.
Q: How did the government make its case?
A: The complaint, filed late Monday in federal court in Los Angeles, includes a trove of emails and other documents aimed at proving that S&P knew the housing market was melting down long before it changed its ratings.
In March 2007, for example, one analyst wrote an ode to the subprime mortgage meltdown, emailing colleagues with a takeoff on the song “Burning Down the House” by The Talking Heads.
“Watch out/Housing market went softer/Cooling down/Strong market is now much weaker/Subprime is boi-ling o-ver/Bringing down the house,” he wrote. A few days later, the analyst sent a video of himself singing and dancing that verse in S&P offices, with colleagues laughing.
Yet S&P kept rating subprime-backed investments as safe, the government says.
Q: So who’s going to jail?
A: No one. The charges are civil, so the harshest penalties would be fines and limits on how the company does business.
In general law enforcement officials have had a tough time making criminal cases against high-profile people involved in the 2008 financial crisis. Justice Department officials have argued that they simply don’t have the evidence to prosecute criminal cases, which would carry a higher burden of proof than civil charges.
So most of the cases related to the crisis have been actions by regulators or lawsuits against small-time mortgage industry workers who committed on-the-ground fraud. No major Wall Street executive has faced the threat of jail time in relation to the crisis.
Q: Have lawmakers fixed the credit rating system?
A: There have been some reforms, but critics say they don’t go far enough.
Under the 2010 overhaul of financial rules known as the Dodd-Frank Act, the Securities and Exchange Commission gained stronger powers to oversee rating agencies. Safeguards were put in place to prevent banks from shopping around for the best rating.
Some proposals went farther. One would have randomly assigned a rating agency to each investment. It did not make the final bill.
Daniel Wagner can be reached at www.twitter.com/wagnerreports.