Standard & Poor’s pays for giving AAA ratings to mortgage-backed securities that turned out to be little better than junk.
Yesterday, U.S. Attorney General Eric Holder announced that the Department of Justice and the attorneys general of 19 states plus the District of Columbia had reached a settlement in their lawsuits against Standard & Poor’s for its central role in fueling the subprime mortgage meltdown of a half-decade ago.
The Role of the Rating Agencies
A credit rating agency is very different from a consumer credit reporting agency, like Equifax) that provides personal credit scores. In contrast it is a company that, among other services, assigns credit ratings for financial and other institutions on the debt obligations that they issue, such as securities and bonds. These assigned credit ratings are relied on by investors who are considering whether to invest in those securities and bonds, helping them make good decisions about the riskiness of those investments.
Credit rating agencies play an indispensable role in the in the creation and sale of mortgage-backed securities and thus in the U.S. financial system as a whole. They hold themselves out to be objective, independent, and reliable sources of information for investors about the safety of potential investments. Most of the time, these securities have to have a favorable rating from a respected credit rating agency for investors to be willing to invest in them. In fact, often the investors are not allowed to put their money into such securities and bonds otherwise. So having a good rating is often essential to the successful sale of a set of securities and bonds, the difference between an issuer of those financial instruments being able to generate the profit is wants, and not being able to.
The DOJ’s Original Allegations Against S&P
Almost exactly two years ago the Department of Justice sued S&P. Its Complaint alleged that S&P systematically defrauded investors in mortgage-backed securities, resulting in losses for those investors amounting to billions of dollars. Its alleged ongoing scheme occurred from 2004 through 2007, and intended to provide inflated credit ratings for mortgage-backed securities in order to enrich itself. By making these securities look like safer investments than it knew they were, S&P would keep getting hired and paid by the banks that were creating and selling these mortgage-backed securities. The alleged direct result of S&P’s fraudulent scheme was that the buyers of these securities—specifically federally insured financial institutions—lost billions of dollars when most of these investments became worthless after having received intentionally inflated credit ratings from S&P. The Department of Justice’s Complaint demanded $5 billion in penalties against S&P.
The Terms of the New Settlement
S&P has agreed to pay the Department of Justice $687.5 million, and the 19 states plus the District of Columbia an additional $687.5 million, a total of $1.375 billion, all within 30 days. This amount exceeds the company’s profits earned for providing ratings for mortgage-backed securities during the period covered.
S&P did not directly admit to any violations of law, but it did “acknowledge the facts set out in” a 16-paragraph Statement of Facts. A press release of Tuesday, February 3, 2015 from the Department of Justice summarized these acknowledged facts as follows:
… S&P admits that its decisions on its rating models were affected by business concerns, and that, with an eye to business concerns, S&P maintained and continued to issue positive ratings on securities despite a growing awareness of quality problems with those securities. S&P acknowledges that:
S&P promised investors at all relevant times that its ratings must be independent and objective and must not be affected by any existing or potential business relationship;
S&P executives have admitted, despite its representations, that decisions about the testing and rollout of updates to S&P’s model for rating CDOs [Collateralized Debt Obligations] were made, at least in part, based on the effect that any update would have on S&P’s business relationship with issuers;
Relevant people within S&P knew in 2007 many loans in RMBS [Residential Mortgage Backed Securities] transactions S&P were rating were delinquent and that losses were probable;
S&P representatives continued to issue and confirm positive ratings without adjustments to reflect the negative rating actions that it expected would come.
In return the Department of Justice and the state attorneys general agreed to dismiss its lawsuits against S&P and release all claims against it for any wrongdoing related to its credit rating of the debt and securities instruments during the 2004-2007 period at issue.
The settlement does NOT release, and leaves open for possible further litigation:
The liability of any individual person—the settlement is only with S&P and its corporate parent—not any of their managers or employees
Any criminal liability
Any potential lawsuits brought by private persons or entities
Any claims by county, municipal or other local pension funds
Any claims by any local governments