The Securities and Exchange Commission took the bold step of filing charges against Standard and Poor’s, one of the three giant rating agencies. Personally, I think the role of rating agencies in the run up to the 2008 financial crisis has been under-appreciated. Without the the top AAA rating they bestowed on securitized mortgage bonds, the flow of cash into those toxic instruments would have stopped much earlier and decreased the size of the bubble.
The SEC complaint claims that S&P continued to give subprime mortgage securities high ratings as the the securities looked increasingly fragile and financial crisis began to bubble to the surface. In the first half of 2007, S&P rated a large number of large mortgage-backed securities, bestowing top grades on the investments. It then quickly downgraded the securities, which defaulted in months.As a result, federally insured banks incurred losses. That gives the SEC jurisdiction.
As with any government investigation, the SEC found emails saying stupid things. In one case there is a March, 2007 satire in an email based on the Talking Heads song “Burning Down the House”:
Housing market went softer
Strong market is now much weaker
Subprime is boi-ling o-ver.
Bringing down the house.”
The SEC claims that S&P knew that the performance of non-prime residential mortgage backed-securities was bad and getting worse. The firm expected deals to rush in before those packaging the mortgages were stuck with them on their books. The SEC takes individual instances of ratings failures by S&P and ties them to losses sustained by the banks that bought them.
Another e-mail from an analyst in response to a question about how his new job was going reads:
“Job’s going great. Aside from the fact that the M.B.S. world is crashing, investors and the media hate us and we’re all running around to save face … no complaints.”
But then went on to state the central part of the case:
“The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.”
This might shake out a completely different way of doing biz in the industry. I mean come on, we pay you to rate our deals, and the better the rating the more money we make?!?! Whats [sic] up with that? How are you possibly supposed to be impartial????
There is an unforgiving conflict in the way mortgage bonds were rated. The issuer pays for the ratings work. So there is an incentive by the ratings agency to met the issuer’s expectations, keep them happy, and retain their business.
Finally, in July, 2007, S&P downgrades 612 classes of RMBS, totaling $12 billion in securities. Of course it was too late for the securities that S&P had favorably rated just days and weeks earlier. It is the ratings issued between March and July of 2007 that the SEC is focused on this complaint. The SEC claims that S&P could see the walls crumbling, but held back saying anything to appease the pipeline of deals in the works.
My big unanswered question is whether the SEC is going to make a similar case against Moody’s and Fitch.
- Complaint against S&P (.pdf)
- Justice Department Faces Uphill Battle in Proving S.& P. Fraud by Peter J. Henning and Steven M. Davidoff in DealBook
- The Risk Management Formula That Killed Wall Street