A costly opinion

By Sebastian Preuss

Last week Standard & Poor’s (S&P), one of the largest credit rating agencies worldwide, entered into a settlement with the US Department of Justice, agreeing to pay roughly $1.3 billion to end a lawsuit over fallacious ratings issued prior to the Financial Crisis of 2007. Although S&P explicitly denied any wrongdoings in connection with their rating practices, this settlement might nonetheless set an example.

Credit rating agencies like S&P, which controls around 40% of the credit rating market, traditionally provide information on the credit worthiness of countries, governments and large corporations. During the early 2000s, they also started to issue ratings for so called structured finance products, which pooled several assets to form a new class of securities. Most of these structured products received very favorable ratings although the underlying assets were all but riskless. During the 2007 crisis, these papers suffered severe losses, despite their rating as practically safe. In the aftermath, investors turned to the rating agencies that had issued these ratings for compensation. Indeed, several cases where investors sued for damages have been ended through settlements. How is this one different then?

S&P was the first rating agency being sued by the US Department of Justice, involving not only damages but also fraud charges. With the settlement of last week, the stage is set for the other big players, Moody’s and Fitch, which together with S&P accumulate a market share of just above 95%. At this point, Moody’s is under investigation, with experts suspecting similar allegations as in the case of S&P. The Department of Justice’s attention is not unsubstantiated, as it is widely assumed that it was in fact the rating agencies’ practice of inflating credit ratings for structured products that fueled the US housing bubble, eventually leading to the financial crisis. With the menace of fraud charges, this practice might be put to an end.

Generally speaking, rating agencies claim that their ratings merely express opinions, which provides a powerful protection against most allegations. The charges for fraud against S&P were based on e-mail conversations between employees, implying that their ratings for mortgage backed securities were simply too good to be true.  Statements like this open a new way for prosecutors: If ratings are not independent and objective, S&P might well be guilty of fraud.

However, the settlement was agreed upon without admission of guilt, which implies that S&P still can deny any fraudulent behavior of management or employees. Despite the magnitude of the deal, which wipes out a year’s profit for S&P’s parent company McGraw Hill Financial, the message would have been even clearer with a plea of guilt. Indeed, some regard this deal as a setback on the way to meaningful reforms in the industry. So far, ratings are ordered and paid for by the party issuing the securities in question, which creates a strong bias towards favorable ratings. What is more, the rating agencies were usually involved in the structuring of products they rated. The resulting conflict of interest is now being questions by investors and regulators alike.

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