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S&P raises desperate defense against government lawsuit

The credit rating firm being sued for its role in the financial crisis essentially argues that no one should have taken its ratings seriously in the first place.

September 06, 2013|Michael Hiltzik
  • S&P says its ratings "are not indicators of investment merit, are not recommendations to buy, sell or hold any security, and should not be relied upon as investment advice."
S&P says its ratings "are not indicators of investment merit,… (Justin Lane / European Pressphoto…)

Everybody wants to see the perpetrators of the financial crisis punished, but you have to feel a little sorry for Standard & Poor's, the credit rating firm being sued by the federal government for its role in the disaster.

S&P clearly has its back to the wall in this case. We can conclude this from the desperate defense it raised in court last week: that federal prosecutors have their knives out for S&P in "retaliation" for its downgrade of the U.S. government's credit rating in August 2011.

As a diversionary tactic, the assertion is brilliant — it certainly got prominent play in newspapers and news websites across the nation. But as a legal claim, it's openly preposterous. And it clumsily sidesteps the main question, which is whether the firm is indeed guilty of fraud.

A lot is at stake in this legal battle. The government is seeking the recovery of more than $5 billion in losses the firm allegedly caused investors by endowing toxic mortgage securities with undeserved gilt-edged credit ratings.

Its lawsuit, filed in February in Santa Ana federal court, cites numerous internal memos and email exchanges suggesting that S&P knew the mortgage market was tanking. Still, the firm maintained glittering credit ratings on mortgage securities to suit its clients — the banks that were issuing the crummy securities and needed to dress them up with AAA ratings before hawking them to investors.

The government contends that S&P committed fraud by continually asserting that its rating process was immune from client pressure and therefore rigorously objective. Investors who bought the mortgage securities thinking an S&P rating was the product of pristine analysis, in other words, got taken.

Over the last few months, S&P has tried out several defenses against the government's allegations. They've been increasingly implausible, but its latest claims, filed in court last week, take the cake.

Let's examine the "retaliation" defense first. What's endearing about it is that it shows there are people in the world who still take S&P's 2011 downgrade of the U.S. government seriously: S&P's lawyers, namely.

The downgrade made big news in 2011 for several hours. S&P had warned for months that it was coming, because Washington gridlock was hampering efforts to reduce the federal deficit. Numerous pundits speculated that a downgrade would drive up interest rates on treasuries, raising borrowing costs for the government. "We'll be in uncharted waters" was the general refrain.

So what happened when the downgrade arrived? Interest rates on treasuries actually plunged: The rate on the 10-year bond, about 2.56% the day of the downgrade, bottomed out at 1.62% in May. (It has since moved up, mostly out of concern that the Federal Reserve will stop easing.) The political gridlock in Washington has, if anything, grown worse, yet the federal deficit has been cut in half as a percentage of gross domestic product.

In its filing last week, S&P doesn't mention who would have ordered this supposed retaliation, or how, or why anyone in the government would care about the downgrade, given how the event has mostly hurt S&P's already tattered reputation for financial percipience.

What got lost in all the news coverage of the retaliation claim was an even more remarkable defense S&P offered in the same document. There S&P essentially argues that no one should have taken its ratings seriously in the first place. Its ratings, it says, "are not indicators of investment merit, are not recommendations to buy, sell or hold any security, and should not be relied upon as investment advice."

That flies in the face of what ratings firms are actually supposed to do. They're in business to provide investment advice. If you're an investor aiming to buy credit instruments, the No. 1 question you have is: How creditworthy are they? That's the question that firms like S&P exist to answer.

So if not that, then what did S&P do for its money? Its lawyers don't say, but followers of the investment game know the answer. The firm provided cover. No securities trader would be fired for taking the plunge on a mortgage-backed security, no matter how dubious, if it bore the seal of approval of S&P (or its rival credit rating firms, Moody's and Fitch).

The ratings S&P claims are meaningless, by the way, didn't come cheap: S&P charged up to $750,000 to rate a single tranche, or portion, of a basket of mortgage-backed securities known as a collateralized debt obligation. The firm collected more than $1 billion in revenue from investment banks and other issuers for all sort of mortgage securities from 2005 through 2007, the period during which the federal government says it kited its ratings sky-high.

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