Attorney General Eric Holder of the Justice Department. Photo Credit: U.S. Justice Department.
WASHINGTON – Blaming credit rating agencies at least party for the financial collapse, the Department of Justice filed suit on Tuesday against Standard and Poors for having given the highest rating – AAA – to a number of complex bonds that later proved to be nearly worthless.
As of yet, this is the first such lawsuit against a rating agency, prompting criticism that it may have been motivated by S&P’s downgrade of the U.S. economy in 2011.
Host Carmen Russell-Sluchansky spoke with Jeffrey Manns, a law professor at George Washington University Law, to discuss the lawsuit.
First of all, this is about these securities, the RMBS, the residential mortgage-backed securities, which I guess are very complex instruments, ways of making money of of mortgage debt.
Sure, the basic idea is, as opposed to bank each having a mortgage issued, holding on to the mortgage, you can bundle together thousands of tens of thousands of them, divide up the trenches in terms of the what’s coming out of mortgage payments and then sell these interests on to investors. What is complicated about them is that it all depends on how you go and divide up the trenches. So, in other words, rating agencies were called upon to look at the instrument as a whole and to look at individual trenches of the securitized instruments and then say what the credit worthiness of each individual trench was.
And it turns out they were not so credible, or they at least were probably not for the triple A rating. I mean, do we first of all know? Were there any expectations that they really maybe were, and that there were other factors in place when it came to the fact that they ended up bottoming out?
Sure. The big challenge is high insight bias. Anyone can say that the financial crisis happened and indeed the underlying assumptions are that underpinned many ratings to prove to be incorrect. The challenge of course is rating agencies can possibly say they issued opinions, they made a set of assumptions, at the time they believed these assumptions were accurate and they merely proved not to be accurate. So, to summarise S&P’s response, the Department of Justice lawsuit could be easily said to be – “ you are effectively blaming us for not predicting the financial crisis, by the way, the Federal Government didn’t either”.
Then not only that, I did read their response, the same that they issued. They said, there was other credit rating agencies - same exact thing.
In that rate, this is another issue entirely which is the nature of the allegations against Standard & Poor’s, to kind of quickly summarize what they are, the government is using an anti-fraud provision from a statute that was enacted in response to 1980s banking crisis. And this fraud statute says that the government can go and pursue fraud actions when the fraudulent conduct “affects the federally insured financial institution”. That is very broad. What they have to go and show is that S&P knowingly committed fraud in issuing its ratings. The type of info they focus on, or the type of allegations in may ways will be similar to the type of conduct that Moody’s or Fitch, the other two leading rating agencies would have done in the run of the crisis. In other words, the government is going and alleging that Standard & Poor’s presented themselves as being independent objective when it was rating RNBS and CDO trenches but that it wasn’t. It is saying that S&P Limited adjusted delayed updated ratings, in other words, they knew changed circumstances and they didn’t change the rating to reflect them, and ultimately they are alleging that S&P knowingly disregarded the true extent of the risks. What is telling about this is that this basic set of charges could be made against any number of the leading rating agencies, which often had remarkably similar ratings.
So, in other words, not only is it a matter of whether they were wrong but if they were wrong, they had to know they were wrong at that time.
So, the key is there are two things to think about – the rating is issued when the piece of debt is initially issued to the market place, but then ratings change. If the underlying assumptions prove to be incorrect, rating agencies do have a duty to go about and update those ratings to reflect current information, and rating agencies have historically been criticized for being slow in issuing rating changes. Their defense would be, they are offering long-term structural assessments of credit worthiness and if they were too hasty in going about and changing a rating, it could have significant unintended consequences for financial markets.
One or the other criticisms at least some people have accused the credit rating agencies of doing is not changing them, not actually giving this kind of high ratings simply because their business is tied to the banks that they are rating, that they do rely on these banks for that business. By any chance, is that a play here?
That certainly is a play, that goes to first kind of basis of the fraud that I mentioned that the agency is alleged in, that S&P presented itself as being objective and independent in looking at RNBS and CDO issuances but in practice they led the business interest get in the way. That is the allegation. So, SNP’s response would be that we have a Chinese walls, walls of separation, separating the business side of what we do and the rating side of what we do, and while there may be instances where the business side may have tried to influence ratings, S&P will argue that the business side did not shape the course of ratings.
Due Diligence brings you in-depth news and analysis on politics, law and policy – all things Washington. You get no pre-packaged pundits or 30 sound bites. Rather, we always bring you the top minds and the top newsmakers to present unabridged dissection of the day’s events. Join host Carmen Russell-Sluchansky on Due Diligence as he breaks the news and gets answers and explanations from the people who make it.
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