The financial crisis could never have happened without credit-ratings agencies issuing stellar ratings of toxic mortgage securities that inflated the bubble. Before the Justice Department filed civil fraud charges this week against Standard & Poor’s, the nation’s largest credit-ratings agency, it seemed as if the ratings industry — which reaped record profits in the boom years — was going to escape, unrepentant and unpunished.
That may now change. But the underlying problem — a lack of proper regulation of the industry — remains unresolved.
Nearly three years after the passage of the Dodd-Frank financial reform law, there is no sign that federal regulators are willing to propose, let alone complete, tough rules to reform the agencies. Worse, regulators have repeatedly asserted legal positions that shield the agencies from investor lawsuits, despite questions of misrepresentation, negligence, and fraud in the rating of mortgage investments.
Still, the suit against S&P and its parent, McGraw-Hill Companies, is a move toward accountability. It alleges that from 2004 to 2007, S&P “knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors” in certain mortgage-related securities, and that the agency falsely represented that its ratings “were objective, independent, and uninfluenced by any conflicts of interest.”
What sets the case apart is that the government brought the case rather than water down a settlement to suit S&P’s demands. The government originally sought a penalty of more than $1 billion and an admission of fraud.
When S&P balked, the government sued and now seeks a $5 billion penalty. Too often, the government has accepted settlements with fines that are too small compared with the harm done, and allowed the defendants neither to admit nor to deny the charges.
The Justice Department brought the case not under federal securities law, which has proved difficult to apply, but under a 1989 banking law that is intended to protect taxpayers from fraud against federally insured financial institutions. The government faces a lower burden of proof when the victims are federally insured banks.
In contrast to private securities’ lawsuits, it also can issue subpoenas to gather more evidence. This sort of aggressive legal theorizing has been missing from the government’s approach to potential civil and criminal cases stemming from the financial crisis.
For years, the ratings agencies defended themselves in private parties’ civil lawsuits by saying that their ratings are independent opinions, protected by the First Amendment. A court ruling found that the questionable ratings are not opinions, but misrepresentations.
The government’s case will benefit from that view. By charging S&P with violating its own standards in issuing top ratings for trashy securities, the government has lifted the allegations out of the realm of shoddy practices and into the realm of fraud — where they belong.
— New York Times