More than five years have elapsed since the turbulence that led to the 2008 financial crisis began, and stock markets are once again flirting with levels that they haven’t seen since then. Only now, however, is the Justice Department stepping forward to accuse McGraw-Hill Cos. and its Standard & Poor’s Ratings Service of mail fraud, wire fraud and financial institutions fraud. The charges, filed in federal court in Los Angeles late Monday, relate to the way S&P rated mortgage bonds before the crisis. More than a dozen state prosecutors are reportedly expected to join the lawsuit, while New York’s attorney general is preparing a separate case.
With so many still frustrated at how few bankers have been held to account – a jury acquitted two former Bear Stearns hedge fund managers of criminal charges of conspiracy and securities and wire fraud three years ago – the quest for culprits goes on. It’s about time, some Wall Street critics will say, or maybe better late than never. The action could also lend credence to those who insist that entities besides banks were responsible for the crisis. Yes, investment banks underwrote the risky securities, repackaging them into collateralized debt obligations and then reselling subprime securities within new structures, but those structures were bestowed triple-A credit ratings by the likes of S&P.
Certainly, the activities of the rating agencies – and not S&P alone – played a role in the debacle. The problem with the ratings agencies wasn't with their corporate credit ratings, but with the ratings of structured products like collateralized debt obligations or CDOs. The advent of CDOs and similar products really changed the balance of power between a rating agency and its clients. Theoretically, the potential for conflicts of interest existed for corporations issuing bonds, too. In practice, though, it was hard for a rating agency to systematically overlook publicly available financial information about a bond issuer and still retain the credibility required to be relevant to investors and subscribers.
CDOs are an altogether different type of security. They’re not transparent; it is significantly more difficult for an outside investor to “fact check” a credit agency’s rating. Moreover, while companies looking for debt financing just needed their bonds rated – even if the ratings were B-plus rather than A-minus – that wasn’t the case for CDOs. A structured product of that kind simply wouldn’t sell if it didn’t earn a triple-A rating on its top tranche. No triple A, no deal; no deal, no fee. And those fees could range from $500,000 upwards – per transaction. It was a highly lucrative business.
Anyone surprised that prosecutors have been so persistent in trying to build a case against the rating agencies should look back at the testimony delivered to the Financial Crisis Inquiry Commission in the aftermath of the debacle. Mark Froeba, a former Moody’s employee, told the commissioners that once credit analysts at the rating agency had worried that “we would contribute to the assignment of a rating that was wrong.”
But at the height of the subprime financing bubble, that had shifted. Now, the greatest fear was doing something “that would allow him or her to be singled out for jeopardizing Moody’s market share,” and unfortunate analysts who lost a deal to rival S&P had to justify why that had happened. So a bank looking for a triple-A rating didn’t have to push too hard – enough analysts feared being labeled uncooperative or too demanding.
“They would threaten you all the time,” another former Moody’s employee, Gary, Witt, told the FCIC, according to its later report. (For the record: there is no word that the Justice Department is contemplating similar action against Moody’s. Meanwhile, S&P has said that the proposed case is without merit.)
It is possible that the Justice Department filed charges in hopes of pushing S&P and McGraw-Hill into settling. That may still happen, and the odds are high that jurors will never end up ruling on the case. Taking the case to a jury is a high-risk outcome for both sides. As the Bear Stearns case and others have demonstrated, it’s hard to explain complex financial concepts to those who don’t work within the financial industry itself. For S&P and McGraw-Hill, the risk is even greater: Even without understanding the nuances (or perhaps because they don’t understand the nuances), the average American is still furious that no one put the brakes on the subprime bubble before it wiped out the value of their home.
In some ways, this is similar to the “Abacus” case the SEC brought against Goldman Sachs in early 2010. That case publicly highlighted some of Wall Street’s usual practices –Goldman, for example, clearly distinguished between different kinds of clients and the duties that it owed to each. Those practices, while legal, astonished observers from beyond Wall Street. (Goldman eventually settled that case, admitting to inadequate disclosure on its part, but has always insisted that it’s up to the buyer to do his or her own due diligence and that it isn’t Goldman’s job to do that for them.)
A case against S&P would shine the same kind of spotlight on the extent to which credit analysts violated their own standards in evaluating the CDOs put together by various financial institutions in the interest of capturing big fees and market share. It was widely understood in 2008 and 2009 that this likely had happened (and likely was discussed even before those years among those on Wall Street), but highlighting specific examples and making them the basis for a legal action would put the whole business model up for scrutiny.
It’s all in the eye of the beholder, and that is likely to be one of the arguments made by S&P in the event that a defense is required. Its ratings are simply opinions – covered by free speech – and it’s up to investors who use them to do their own evaluation of the merits of those opinions. Did investors realize that, though? Should it reach a courtroom, that’s likely to be a key point of debate.
There is a lot at stake here. While some institutional investors have developed their own teams of analysts, many others have not, or still rely on the work done by S&P, Moody’s, Fitch and other ratings firms as a starting point. The ratings agencies play another important role as outside arbiters for institutions that have guidelines as to what kind of credit quality they can or can't own. Without S&P or Moody’s to say that a specific company’s credit has fallen below investment grade, who would make that call? Citi? J.P. Morgan? Their analysis is hardly better or more independent.
A settlement or verdict that shakes up that status quo could damage the credit-rating industry and leave investors in limbo at a particularly critical point in the interest rate cycle. The Federal Reserve has kept rates so low for so long that rates alone no longer reflect the real amount of risk that a bond investor is running, making analysis more critical.
Clearly, that analysis needs to be trustworthy and any misdeeds that are proven demand punishment. At the same time, we may also want to stop and ponder the unintended consequences of any punishment. The Justice Department’s lawsuit could end up leaving bond investors with less clarity at a time when the market for those investments is growing more treacherous.