If you think Moody’s (NYSE:MCO) and Fitch — the two debt ratings agencies not sued by the U.S. government Tuesday — dodged a bullet, you’d best think again.
Standard & Poor’s, a division of McGraw-Hill (NYSE:MHP), might have been singled out by the Feds for first blood, but this is just the beginning of a long, painful period of litigation, legal leverage, probable shareholders lawsuits — and, yes, eventually settlements — for all three ratings agencies.
The debt ratings agencies were the “key enablers of the financial meltdown,” as the Financial Crisis Inquiry Commission put it, since it was their bogus ratings of trillions and trillions of dollars of mortgage-backed securities and related derivatives that helped the whole system to implode.
And none of them has been held to account — until now.
The U.S. is suing S&P for fraud, accusing the firm of knowingly giving inflated ratings to risky debt securities and being willfully slow in downgrading those securities when they were obviously dodgier than S&P initially said.
S&P issued credit ratings on more than $4 trillion worth of residential mortgage-backed securities and related derivatives from September 2004 through October 2007, according to the lawsuit — debt that went so sour, it helped spark the worst crisis since the Great Depression.
It’s not clear why the Department of Justice went after S&P first and all by itself. The government and S&P were looking to settle, according to The New York Times, but talks broke down when the Justice Department demanded fines of more than $1 billion and an admission of wrongdoing.
It’s possible the government went after S&P because it offers a treasure trove of smoking guns and the always requisite embarrassing emails. (It also had the temerity to downgrade the U.S. government’s credit rating, S&P says.)
Then, of course, there’s just the strategy of the thing. The action against S&P serves as a loud warning shot — and leverage — against the other two agencies.
After all, S&P was hardly alone in this alleged fraud. By some accounts, Moody’s played even faster and looser with ratings.
Indeed, because the agencies were paid by the very issuers of the debt for ratings — and the deals were so lucrative — competition for business was fierce. And it quickly became a race to the bottom.
As the Justice Department says in its complaint:
“Considerations regarding fees, market share, profits, and relationships with issuers improperly influenced S&P’s rating criteria and models.”
It’s pitifully easy to accuse Moody’s and Fitch of doing the same.
Standard & Poor’s will almost certainly settle. After all, these things always seem to get settled — especially when they’re civil and not criminal complaints, as in this case.
That means Moody’s and Fitch now have a pretty simple choice. They can come to a settlement with the government sooner — as S&P failed to do — or get sued themselves later. And then settle, anyway.
Either way, investors in Moody’s and S&P are going to be dealing with legal risk and some tamped-down share prices for a while.
As of this writing, Dan Burrows did not hold positions in any of the aforementioned securities.