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Controversial New Theory: S&P Got A Few Ratings Wrong

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One day - one day soon - the Justice Department will sue S&P for mis-rating a bunch of CDOs, and when that happens let's all read the complaint and then meet back here to discuss it, okay? [update!] In the meantime we have S&P's preemptive denial:

A DOJ lawsuit would be entirely without factual or legal merit. It would disregard the central facts that S&P reviewed the same subprime mortgage data as the rest of the market – including U.S. Government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained – and that every CDO that DOJ has cited to us also independently received the same rating from another rating agency.

I submit to you that this is not a great defense, though it has a certain intuitive appeal. If in fact it turns out that S&P knowingly gave terrible CDOs AAA ratings because they were being bribed by investment banks or whatever, then it doesn't help them much that Moody's, say, gave the same CDOs the same AAA ratings with pure hearts and empty minds.1 Intent matters; being evil makes you more liable than does being stupid.

More interesting, though, is the claim that "S&P reviewed the same subprime mortgage data as the rest of the market." First of all, that's an almost magically ridiculous statement. (Though, also: true!) S&P's credit ratings not only had the force of quasi-law in 2007 when they were bopping around misrating CDOs: they still have the force of quasi-law today, and there's no plan to change that. Basel III regulations rely on ratings-agency ratings all over the place. And yet S&P has no actual advantage over anyone else in deciding what's a good credit risk.

So why would you rely on S&P to tell you what's a good credit risk? There are two answers, corresponding to two imaginable types of investor. Type 1 investors say, "we relied on S&P because we're wee naïve investors and don't have the capacity to analyze credit ourselves." Particularly for very highly rated and complex structured products, this is an appealing answer. Someone buying a BB bond of an actual company is probably making some sort of relative-value judgment that the credit is better than the rating (really, the spread) implies; someone buying a AAA structured bond with a 500-page prospectus is more plausibly doing so because they just want a safe place to park their cash and they assume that the AAA means that they never have to worry about it.

Type 2 investors say, "we paid attention to S&P because we were forced to." They don't necessarily trust S&P's judgment, but they're banks or money market funds or whatever and due to capital or other regulation are forced to restrict themselves to AAA securities. They might be quite sophisticated - they might understand that higher returns come with higher risks, and that an AAA rating isn't a guarantee of anything - but doing their own analysis about whether AAA-rated CDOs or A-rated corporate bonds were a better investment would be a waste of time. If you can't buy A-rated bonds, the fact that they're a better investment than AAA-rated CDOs is irrelevant. And if you're limited to AAA rated things, and you have all the usual comp convexity that comes from being an employee of an institutional investor, why not invest in the riskiest and highest-yielding AAA things you can find?

You can try to peer into the souls of various investors to tell which was which, but I'd think that a key data point is that AAA-rated CDOs traded wider than AA-rated corporate bonds.2 If investors mostly trusted S&P to do their credit work for them, and believed that AAA was AAA and that anything AAA was safe as houses, then that wouldn't be the case. If, on the other hand, investors mostly knew that AAA CDOs were less safe than AA corporates, then they'd demand a higher yield on them. But they'd still buy them because they checked the AAA box.3

Whether you were a starry-eyed idealist or a cynical realist in relying on S&P's AAA structured credit ratings, you ended up in the same place: poorer. But not everyone ended up in the obvious next place: in court, suing for securities fraud. In part this is because of ancient First Amendment protections for ratings agencies; in part, it's because "we knew this bond was risky but we bought it anyway to get some extra yield out of the misrating" isn't all that sympathetic a legal claim. If you want to sue for fraud, you have to claim reliance; if you were using the rating only to check regulatory boxes, and not to make an investing decision, your reliance claim isn't that strong. The result is that the only people who've had any success suing the agencies can plausibly argue that they actually cared about the rating as an indicator of risk, and that the agencies knew it. Those cases are pretty rare.

Now the DoJ supposedly wants 10 figures worth of damages from S&P, and there's a certain logic in that. Not having read the complaint, I'm going to go ahead and guess that it will charge that S&P conspired with banks to give CDOs misleadingly high ratings, but that won't be quite right. S&P, banks, and institutional investors all had incentives to work together to build a market in which relatively risky, relatively high-yielding things got relatively high, relatively undeserved ratings. Those investors don't necessarily look like innocent victims, so they're not all that well situated to sue.

But somebody had to have been the innocent victim, right? That market led to gazillions of dollars of losses, a recession, and a global financial crisis. So someone should sue, and since direct innocent victims are hard to come by it makes sense that the DoJ will be doing the suing. It's not entirely clear, though, that S&P are the right people to cough up all the damages.

Standard & Poor's Says Civil Lawsuit Threatened By DOJ Is Without Legal Merit And Unjustified [PRNewswire]
U.S., States Plan to File Civil Charges Against S&P [WSJ]
U.S. and States Prepare to Sue S.&P. Over Mortgage Ratings [DealBook]

1.The "U.S. Government officials" line is an even lower blow. One, who relies on U.S. government officials to rate securities? Two, saying "problems in the subprime market appear to be contained" could just mean "... contained within the subprime market. But anyone who owns subprime CDOs is fucked." Etc.

2.Ten seconds of Googling doesn't immediately provide proof of that last with S&P data, but here is a Moody's report showing Aaa structured finance spreads consistently outside of Aa corporate spreads from 1998 to 2004 (pages 7-8).

3.Thus, CPDOs: a pure creature of ratings-agency terribleness, designed to have the highest spread and worst credit quality possible in a AAA investment. Some people bought them knowing that; others were Australian town councils who were just seduced by the AAA rating. The councils sued.