The bankers responsible for the financial crisis, who packaged and sold subprime mortgage securities that turned out to be nearly worthless, didn't do it alone. Among their chief collaborators were the credit rating agencies whose job it was to objectively evaluate the risk to investors. Without these professionals slapping top AAA ratings on toxic subprime instruments, there wouldn't have been many investors. This central role is finally being held up to scrutiny in a $5 billion civil fraud case filed by the Justice Department against Standard & Poor's, one of the nation's three major credit rating agencies. Some justice could be on the horizon.
During the height of the 2008 crisis it became clear that trillions of dollars of junk securities tied to the American housing market had been rated as if they were financial gold and as safe as government bonds. That top rating was key to allowing institutional investors such as pension funds to buy them. The reason for the slipshod work comes down to one simple fact: backward incentives. The credit rating agencies are hired by the issuers of securities they are evaluating, not the investor looking for unbiased investment advice. Only by providing favorable ratings to their clients did they earn hefty fees.
The suit against S&P and its parent, McGraw-Hill Cos., accuses the company of a scheme to defraud investors by falsely representing that its ratings were objective. S&P's computer models were too optimistic in assessing the riskiness of subprime mortgage securities, and the models were manipulated by staff members to benefit clients, the suit alleges. S&P denies this, but S&P allegedly gave instructions to its employees to use a computer model with lower standards in cases where a transaction didn't pass using a more stringent model.
Encouragingly, the government stood firm when the company refused a settlement that included admitting to at least one count of fraud and paying a fine of $1 billion. The Justice Department went to court rather than let S&P off with a token wrist slap.
As the largest credit rating agency in the nation, S&P was counted on to look out for investors by providing unbiased risk assessments of financial instruments. The trumped-up ratings it delivered instead resulted in a financial mess so large that the economy is still recovering. Maybe this lawsuit will finally hold it to account.