Burning down the house – our view of the US legal action against rating agency S&P

8th February 2013

The US Department of Justice has charged ratings agency Standard & Poor’s with fraud and has published excerpts showing internal concerns from staff about the US housing market in the run up to the crash. One staff member even sent round his own version of the Talking Heads video ‘Burning down the house’.

The Department of Justice has accused the agency of making ‘limited, adjusted and delayed updates’ to its ratings in the crucial years running up to the financial crisis. It says structured debt securities bought by California’s Western Federal Corporate Credit Union were given the wrong ratings and contributed to the failure of the institution. The case will be heard in Los Angeles, not a usual centre for this sort of case.

The news saw shares in S&P parent company McGraw Hill fall 16 per cent the first day the news broke, and 10 per cent the day after. The agency is vigorously denying the allegations and says any excerpts are taken out of context.

The Economist makes an interesting observation – that the US government is suing the agency under the Financial Institutions Reform, Recovery and Enforcement Act, a piece of legislation introduced following the savings and loans crisis ( very loosely savings and loans were the US equivalent of local building societies) of the late 1980s.

But it is bringing the suit as a civil action so that the agency may not be able to use first amendment protections to freedom of speech to defend this part of the action.

 

 

 

Mindful Money has five observations to make.

1. This case suggests that there are several more years of lawsuits before we begin to see the end of various legal actions, but given that we have all suffered, Mindful Money doubts there is going to much compensation to go round.

2. Although we don’t have any particular insight into the mind of the US Department of Justice, the biggest government stick to be used against the ratings agencies and to get them to change behaviour is a legal one not a regulatory one. That obviously has its weaknesses. Although no firm welcomes this sort of legal attack, we wonder just how easy it is to use this kind of legal assault to change behaviour, because it is always difficult to win these cases. Regulation is much more immediate though admittedly it has its flaws too.

3. We fear that this route has almost been forced upon the US by the fact that US legislators have failed to institute any sort of significant regulatory reform. A proposal by Senator Al Franken suggesting that a Government body distribute ratings work across the agencies has fallen by the wayside. The temptation to rate ‘lightly’ to win business surely remains. It may be that the agencies are now ruing winning the lobby fight only to find themselves in court.

4. The European Union so far has not just missed the target but it appears to be playing an entirely different sport. It’s regulatory initiative has obsessed with the rating of countries’ debts. That is not the problem or at least the eurozone problem is not a problem of misrating. The agencies may be too powerful, but the failure came with the ratings of mortgage debt and derivatives pre-crisis. To read the EU initiative, it is almost as if they have forgotten how the financial crisis started.

5. Finally if all this sounds rather divorced from your own financial reality, we would point out that agencies rate all manner of company and government and other debt, forming a huge part of many fund managers’ investment universes. Some of this will be in your portfolio. But frankly no fund manager worth their salt will take what the ratings agencies say as the final word these days. But choose your manager or managers well.

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