Why not Moody’s? Why not Fitch? Of all the questions raised about the U.S. government’s strange case against Standard & Poor’s—a lawsuit that actually asserts that some of the nation’s largest banks were S&P’s “victims,” and that the credit rating firm somehow fooled these banks about products the banks actually created—the lack of similar actions against S&P competitors still rings the most alarm bells.
S&P, Fitch and Moody’s all gave AAA rating to many packages of subprime mortgages that imploded. But of those three, only S&P downgraded the U.S. government from its decades-old AAA credit rating.
Floyd Abrams, the attorney representing S&P’s parent company McGraw-Hill in the litigation and a veteran First Amendment lawyer (and yes, the First Amendment is a strong concern here, as I will get to in a second), has said that the government ramped up its investigation of S&P shortly after the downgrade in 2011. “Is it true that after the downgrade the intensity of this investigation significantly increased? Yea,” Floyd Abrams, S&P’s lead attorney, told CNBC in an interview last week. “We don’t know why.”
The Justice Department’s civil suit against S&P looks even more suspicious when paired with the action a few weeks ago by another arm of the government against a small, upstart credit ratings firm that also had the temerity to downgrade the U.S. In late January, the Securities and Exchange Commission (SEC) stripped rating agency Egan-Jones of its accreditation as a “nationally recognized statistical rating organization” (NRSRO) in rating the creditworthiness of government or asset-backed securities. This was the first time the SEC had ever stripped a rating agency of its NRSRO status, an action that effectively bars financial institutions from relying on the rating agency to meet capital requirements.
Ironically, Egan-Jones’ rating had been widely praised as an alternative to that of the “Big 3” of Moody’s, Fitch and S&P. Receiving its funding through investor subscriptions, rather than payment of the entities being rated, it avoided the conflicts of interest that “Big 3” critics say led to inflated ratings for mortgage securities. The firm also turned out to be prescient in its early downgrades of Bear Stearns and Lehman Brothers, the first institutions to implode in the mortgage crisis.
Egan-Jones also beat S&P to the punch in downgrading the U.S. In July 2011, it changed its rating from AAA to AA+, explaining: “The major factor driving credit quality is the relatively high level of debt and the difficulty in significantly cutting spending. We are taking a negative action not based on the delay in raising the debt ceiling but rather our concern about the high level of debt to GDP.” A few weeks later in early August, S&P would follow suit with its downgrade.
The SEC did not charge Egan-Jones with deceiving investors, but with the relatively trivial offense of misstating its length of time rating securities. The firm had said it had been rating securities since 1995, and it had. But according to Reuters, the SEC is going after the firm because its ratings had not been posted “on the internet or through another readily accessible means.” Never mind that the Internet was just beginning in 1995!
Looking at the actions against both Egan-Jones and S&P, Peter Schiff, CEO and chief global strategist of Euro Pacific Capital, maintains that “the Obama Administration is sending a loud and clear message to Wall Street: mess with the bull and get the horns.” Schiff, who loudly warned during the housing boom of declining home prices and skyrocketing mortgage defaults, says “at most, S&P was guilty of a culture of complacency and group think.”
If that were a crime, everyone who gave rosy assessments of the housing market — from Federal Reserve Chairman Ben Bernanke to former House Financial Services Committee Chairman Barney Frank (D-Mass.), would be in jail. And then there’s the inconvenient fact that the government itself was a key player in the mortgage crisis through “affordable housing” mandates and subsidies from Fannie Mae, Freddie Mac, the Federal Housing Administration, and the Community Reinvestment Act. And as the American Enterprise Institute Peter Wallison makes clear in his new book, Bad History, Worse Policy, Fannie and Freddie misled the entire financial community — including presumably S&P — by misclassifying millions of loans made to borrowers with subprime credit scores as “prime.”
Prosecuting a false opinion or false prediction also raises serious First Amendment concerns. That’s why S&P has retained Abrams, who has argued other famous free speech cases for controversial causes, such as the right of the New York Times to publish classified military information in the “Pentagon Papers” case.
To sidestep free speech issues, the government is attempting to argue outright fraud and prove S&P didn’t believe in the ratings it issued. To do this, it presents selective quotes in emails from company employees who were housing market skeptics. But as Schiff points out, “the company readily admits that it reached its opinions through a consensus and that feelings within the firm varied.”
And the lawsuit, which pursues S&P with a bank fraud statute, actually accuses S&P of duping the very banks that created the securities. As described by moderate Bloomberg columnist Jonathan Weil, “According to the government, Citigroup was defrauded by S&P credit ratings on subprime mortgage bonds that Citigroup itself created and sold. Bank of America, too, allegedly was defrauded by S&P in the same way.”
As Schiff notes, the credit ratings agencies’ power over the economy was “engendered by the bizarre regulatory environment created for ratings agencies by the government itself.” In 1975, the SEC created the designation of NRSRO for credit-rating firms. Regulatory agencies soon began requiring that banks, brokerage firms, pensions, and insurance companies carry mandated levels of securities rated AAA from an SEC-approved NRSRO.
In a truly free market for credit ratings, S&P and Moody’s would be to securities what Zagat is to restaurants, a rating influential because of its reputation but without undue power over a restaurant and its customers. But if that happened, who would the government have to blame for its own grave errors?!
Evan Woodham contributed to this post.