Why the fed’s case against Standard & Poor’s matters to you

Federal prosecutors filed civil fraud charges against Standard & Poor’s for alleged wrongdoing in rating mortgage bonds. This is the first federal enforcement action against a major credit rating agency over alleged illegal behavior tied to the 2008 financial crisis.

For the uninitiated, Wall Street investment banking firms long ago woke up to the fact that their credibility as sellers of financial securities to private investors could be significantly enhanced if these securities were “rated for safety” by so-called independent and objective third parties.

This was especially true for debt securities like bonds, whose likely buyers were perceived as very conservative. Since the market for bonds and other debt securities is far larger than the market for common stocks, development of a third-party rating system for them became a priority for Wall Street.

Three private firms emerged as the most trusted “rating agencies” for debt securities: Moody’s Investors Services Inc., McGraw-Hill subsidiary Standard & Poor’s, and Fitch Inc.

These firms assign “investment ratings” to debt securities based on their analysis of relevant financial data about the issuers. They charge fees to the sellers for rating the debt securities.

The financial community accepted this approach for providing debt securities buyers with “objective” information about their relative safety and these rating systems became a popular shorthand way to categorize the securities. Investment banks routinely used favorable ratings as marketing tools.

Some institutional buyers of debt securities (like insurance companies with streams of premium income to invest) announced that they would only buy securities rated “A” or better. Government and private sector regulators often set minimum ratings for the securities firms they regulated (such as commercial banks) were permitted to buy.

During the run-up to the financial crisis, this business was quite profitable. From 2005 to 2007, Moody’s had a return on capital of 140 percent, the highest among all publicly traded corporations listed in the S&P 500 Index. Its operating profit margin was 53.6 percent. And the firm’s revenues from rating corporate bonds grew by 187 percent. In short, the rating agencies made out like proverbial bandits.

So it doesn’t take much imagination to picture how the relationship might have played out on a typical day in 2007 as the mortgage backed securities and derivative products boom was approaching its climax. Wall Street investment banks delivered risk-profile reports for their latest deals that included mathematical risk models.

Except the formulas and equations behind those models were proprietary, meaning that rating agencies’ reliance on them amounted to little more than “trust me.” The agencies happily made that leap of faith, which benefited their bottom lines to the detriment of those who purchased the securities.

In addition to consistently churning out strong ratings for highly questionable debt securities, they also regularly increased the fees they charged for doing so.

If you conclude that the interaction between big banks and the rating agencies was more like a criminal enterprise than an arms-length relationship between a commercial enterprise and an independent , objective third party, you’re not alone. Federal prosecutors feel the same way.

Now where do all the purchasers of those now-worthless debt securities go to get their money back?

originally published: February 19, 2013

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