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Just two weeks after Standard and Poor’s downgraded the U.S. government’s credit rating to Double-A+, the New York Times reported that the Justice Department is investigating S&P’s ratings of mortgage securities in the lead up to the recent mortgage crisis.
Despite the timing of the news, we know that the investigation isn’t retribution for the downgrade since the investigation precedes the downgrade by months. But the rating agency’s downgrade of U.S. treasuries certainly didn’t help its case, and is construed by many as an effort at establishing S&P independence.
The investigation began with the Securities and Exchange Commission looking into whether S&P and Moody’s Investors Service turned a blind eye to problems with subprime mortgage bonds that it rated prior to the recent financial crisis. The Justice Department joined the SEC’s investigation in recent months.
Critics complain that rating agencies are beholden to the companies and banks that pay for their ratings. In the lead up to the crisis, banks were able to shop around at the rating agencies for the best rating possible on the banks’ mortgage backed securities.
The rating agencies were hesitant to give poor ratings to the banks’ financial products because they risked losing customers, so risky financial products ended up with inflated ratings. The S&P was quick to give mortgage backed securities Triple-A ratings, despite the high risk associated with the subprime mortgages on which the securities were based.
S&P has confirmed that it’s under federal investigation, revealing that it "has received several requests from different government agencies over the last few years regarding U.S. mortgage-related securities," and assuring the public that it has "cooperated and will continue to cooperate with these requests."
The rating investigation probably extends beyond S&P, although Moody’s has not commented on the investigation; and the other major rating agency, Fitch Ratings, has said that it is not aware of any federal investigation into its activities.
In addition to the investigation into the S&P’s role in rating mortgage securities, the SEC has said it plans to investigate this month’s downgrade. The agency is interested in the model S&P used when it downgraded the U.S.’s credit rating and also wants to know who at S&P knew about the downgrade in advance. That’s likely a first step in an insider trading investigation.
Although the consequences of the S&P downgrade and the federal investigations into the rating agency won’t be clear for months or even years, it is very likely that the rating process the financial world has used for decades will change dramatically.
The current system, where ratings are paid for by the banks and businesses that benefit from high ratings, probably will be replaced by a system with fewer opportunities for conflicts of interest. A proposal last year to make random assignments to rating agencies passed the Senate, but was dropped in conference.
Regardless of who wins in the power struggle between the U.S. and the rating agencies, there’s going to be one clear loser: U.S. investors. Despite the clear need for reform of the rating agencies, the process is likely to drag on far longer than needed. What we need is certainty, and that’s about the last thing we can expect from Washington.
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See also The Law Professor's blog at AdvisorFYI.