It cost $1.37 billion, but Standard & Poor’s finally seems to have closed the darkest chapter in its 150-year history as a rating agency.
Yet that payout announced on Tuesday, which will settle an array of government lawsuits that accused S&P of inflating the ratings of subprime mortgage investments, does not represent closure for the broader ratings business. An uncertain future still lies ahead for S&P as well as for its main rivals, Moody’s and Fitch.
In the wake of the financial crisis, when rating agencies were blamed for feeding a sub-prime mortgage frenzy, Congress used the Dodd-Frank Act to adopt a battery of changes for the rating industry. S&P, Moody’s and Fitch announced their own cultural overhauls and struck a competitive tone about whose ratings were the strictest.
Eventually, however, that spirit of reform began to collide with the realities of Wall Street. Despite upstart ventures challenging a ratings oligopoly, S&P, Moody’s and Fitch still dominate the market. Huge pension funds, some of the same investors that took a beating during the crisis, still consider ratings to be a cornerstone of the financial system. Rating changes, up or down, can still move markets.
At the same time that the ratings agencies have reasserted their influence, some signs of trouble have re-emerged. Last month, for example, S&P settled accusations from the Securities and Exchange Commission that it had misled the public about its approach to rating certain commercial mortgage investments — misconduct that occurred in 2011, years after the crisis. And even as S&P has publicly raised concerns about the quality of loans backing subprime auto bonds, it continues to award top ratings to the investments, echoing problems that led to the government settlements on Tuesday. “The $1.37-billion fine shows that the current system does not work,” said representative Brad Sherman, a California Democrat who has co-written legislation to crack down on rating agencies.
At the heart of the problem, some lawmakers say, is the rating agency business model. The agencies are paid by the same banks and companies they rate. And when market share declines, a rating agency might lower its standards to attract new business, a concern that underpinned the US justice department lawsuit that S&P settled on Tuesday. “In reality, the ratings were affected by significant conflicts of interest, and S&P was driven by its desire for increased profits and market share to favour the interests of issuers over investors,” attorney general Eric Holder said at a news conference announcing the settlement. S&P argues that its ratings offer investors a valuable service. While certain ratings might prove to be imperfect, they are meant to be opinions, not fact.
But senator Al Franken, a Minnesota Democrat who has proposed an overhaul of the ratings business, argues that potential conflicts might impair those opinions. “As I’ve said since the financial crisis, enforcement after wrongdoing won’t be enough,” Franken said in a statement on Tuesday, referring to the settlement. He called on the SEC to “fix the fundamental problems of the credit ratings agencies’ conflicts of interest that continue to put everyday Americans and our financial system at risk”.
During the debate over Dodd-Frank, Franken and Sherman proposed an amendment that would install an independent panel to assign bonds to a rating agency, providing a check on potential conflicts. Ultimately, Dodd-Frank required the SEC to study the issue. Beyond the study, the agency did not take further action. It did, however, establish a specialised office of credit ratings that conducts annual exams of the companies.