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Standard & Poor's Settlement Shows Futility Of Fighting Government Policy


forbes.com | February 4, 2015

By Daniel Fisher

The $1.38 billion Standard & Poor’s ratings settlement announced today reminds me of another news item in the New York Times this morning.

Venezuela’s secret police have detained several executives of that nation’s biggest pharmacy chain, the Times reports, for the crime of inciting customers to form long lines and create the false impression of shortages. Rejecting any argument that socialist government policies are to blame for widespread shortages of consumer products, Venezuela’s propaganda minister tweeted: “They should explain why they foster lines in the entrances to their stores.”

Executives at Standard & Poor’s parent McGraw-Hill Financial must feel the same way about announcing its billion-dollar-plus settlement with the Justice Dept. While there is certainly a measure of rough justice in having the ratings agency cough up some money to compensate the federal government and the states for the billions they lost on shoddy mortgage-backed securities in the financial crisis, the lawsuit against S&P stems mostly from policies the government long ago should have ended. First among them: The preferential treatment regulators give banks and other investors for buying triple-A securities, which has the perverse effect of lessening the pressure on them to do their own research.

Like the Venezuelan officials who lock up store executives for fostering lines that are in fact caused by the government’s failure to manage its own finances, the Justice Dept. lawyers who sued S&P were seeking recompense for a crisis largely of the government’s making.

As American Enterprise Institute scholar Peter J. Wallison explains in his recent book, “Hidden in Plain Sight,” Congressional mandates to increase lending to low- and moderate-income borrowers helped drive the demand for lower-quality mortgages and mortgage-backed paper. Wall Street helped supply the need and attempted to craft investment-grade securities out of crap loans by structuring securities with a waterfall of tranches. The highest tranches were expected to pay out in anything but a nuclear holocaust and S&P and Moody’s rated them as such, relying on flawed models and perhaps their own desire to keep the underwriters happy. Underwriters pay for the ratings system, after all.

It’s always possible to build a lawsuit out of facts like these, of course, and the government was under its own pressure to Do Something about the Wall Street practices that contributed so much to the crisis. But was S&P the right target?

Critics noted after the government filed suit in 2013 that Moody’s engaged in the same apparent ratings inflation as S&P, but it hadn’t committed the additional sin of downgrading the U.S. debt. A string of court decisions also appeared to protect the activities of the ratings agencies as their First Amendment exercise of free speech. (While false and misleading speech isn’t entitled to First Amendment protection, courts found the ratings agencies were offering opinions about the safety of securities, and opinions can’t be true or false.)

The buyers of bonds didn’t pay for those ratings, except indirectly, and if they were more diligent they would have performed their own research before entering into multimillion-dollar transactions. Certainly John Paulson, Phil Falcone and other investors were able to see through the ratings smoke and make tens of billions of dollars shorting the very same mortgages that S&P, Moody’s, Fannie Mae and Freddie Mac thought could be made investment-grade through the miracle of structured finance.

Standard & Poor’s came out swinging in this fight. It noted that the lawsuit was based not upon conventional concepts of civil fraud but the Financial Institutions Reform, Recovery and Enforcement Act, a 1989 law that Congress passed, barn-door fashion, to punish the miscreants who took advantage of the government’s misguided partial deregulation of the savings-and-loan industry in the 1980s. By allowing S&Ls to plunge headlong into commercial real estate to try and fix their troubled balance sheets, Congress turned a minor financial crisis into a $124 billion bailout.

FIRREA was an unusual choice, legal commentator Kevin LaCroix noted at the time, but it served a purpose: Since many of the ratings in question were issued years before, FIRREA gave the government a 10-year statute of limitations, at least double the limit for most state and federal fraud claims. The lawsuit was theoretically on behalf of federally insured financial institutions – the very type of investor, I noted above, that should be required to perform their own due diligence on investments.

Fighting the government is often a losing battle, especially in the wake of a major financial crisis blamed partly on one’s own incompetence. But the resolution of this case says a lot about the unusual nature of this wave of post-crisis litigation. The government extracted a face-saving concession from S&P that has nothing to do with the crisis and everything to do with image control: The ratings firm reportedly agreed to drop its claim that it was targeted for suit because it cut Uncle Sam’s credit rating one notch to AA+ in 2011.

Standard & Poor’s got an important concession in return. According to the company’s news release, it admitted to “no findings of violations of law.” That’s exceedingly important as the company battles private lawsuits over the crisis, since class-action lawyers typically build their cases on evidence obtained in government investigations. (New York courts have dismissed a couple such suits against McGraw-Hill, for among other things, First Amendment grounds and the well-recognized doctrine that some claims are “mere commercial puffery” that can’t be the basis for fraud.)

Under the terms of the settlement, the federal government will get $687.5 million and the states will get the same amount (California’s state pension system already settled for $120 million). Spreading the wealth to state attorneys general has become an entrenched part of the system since the the master tobacco settlement, and McGraw-Hill’s lawyers probably knew no deal will be successful without their buy-in.

The Dodd-Frank act did diminish the First Amendment defenses for rating firms and subjected them to heightened Securities and Exchange Commission oversight, especially for conflicts of interest. Meanwhile, the Obama administration has done little to move ahead on another provision of the law that would remove legal references to so-called Nationally Recognized Statistical Ratings Organizations, which some critics say led to excessive reliance on third-party investment analysis in the first place.

Investors seem to like this deal. McGraw-Hill shares rose 2% this morning, close to October’s all-time high of $93.94. At least nobody had to go to jail over it.


Back to February 2015 Archive

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