The U.S. Justice Department announced plans to file civil fraud charges against Standard & Poor's (S&P) relating to the atrocious ratings that Standard & Poor's gave to toxic subprime mortgage-backed securities. (It is unclear whether their cohorts at Moody's and Fitch will be targeted by prosecutors as well.) This is a welcome --if long overdue-- development for investors who have been waiting for years for the Feds to take decisive action against those responsible for crashing the world economy.
New York Times reporters Andrew Ross Sorkin and Mary Williams Walsh report that smoking gun e-mails and instant messages cited by the Feds show that the folks at S&P were not duped by the securities' issuers. They knew exactly what they were doing. One S&P employee wrote, "Rating agencies continue to create an even bigger monster -- the C.D.O. market. Let's hope we are all wealthy and retired by the time this house of card falters." Another wrote in an instant message, "We rate every deal. It could be structured by cows and we would rate it."
To any fair-minded observer, these e-mails sure look like fraud because the rating agencies projected an image that they were "objectively" rating securities that were purchased by pension funds, institutions and ultimately the Mom-and-Pop investors who often had their retirement savings tied up in these funds. Instead, it appears they were slapping bogus ratings on poor-quality, high-risk mortgage bonds just to ensure they got their fees, ignoring the fact that real people were counting on them to give an independent view of the safety of the investments.
The Justice Department action follows a landmark decision by a New York Federal Court holding that investors who were harmed by phony ratings could sue the rating agencies for damages. After years of successfully hiding behind a First-Amendment defense that their ratings were opinions --not objective statements-- and therefore Constitutionally protected as free speech, the Court ruled in 2009 that the ratings were not just opinions but rather misrepresentations resulting from either fraud or negligence. That ruling ripped off the ratings agencies' cloak of immunity and set the stage for the Justice Department's move.
We now know that the rating agencies rated "cows", "dogs" and plenty of "pigs." Every mortgage-backed security and the various tranches or "slices" of these securities dumped on investors had to have the ratings agencies' seal of approval to get out the door. Simply put, nobody would buy them and they couldn't be sold without the rating agencies' imprimatur.
It has been revealed that the rating agencies were paid by the companies they rated. This is reminiscent of the stock analyst scandal of the year-2000 tech bubble where Merrill Lynch, Citigroup and others gave high ratings to companies that did investment banking business with their firms. One hand washed the other, the companies that were given high ratings in essence paid the stock analysts' multi million dollar salaries.
Imagine if a new so-called four-star restaurant paid a New York Times reviewer to give it a top rating. This is exactly what occurred with the rating agencies during the financial crisis, rating "garbage" stocks and bonds as "top-shelf" investment products.
The announcement of the prosecutor's lawsuit crashed the stock price of Standard & Poor's parent, McGraw Hill (MHP), as well as the stock of Moody's (NYSE:MCO).
It really seems that finally, after five long years of just hoping the problem would go away, the chickens are coming home to roost for S&P, and Moody's and Fitch probably feel their collars tightening just a bit as well.
Article originally published on Forbes.com on 2/5/13
Disclaimer: Zamansky & Associates (www.zamansky.com) are securities attorneys representing investors in federal and state litigation and arbitration against financial institutions, including issuers and sellers of mortgage-backed securities.