S.&P. Settlement Leaves Future Unclear for Ratings

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Holder on S.&P.’s Settlement

Attorney General Eric H. Holder Jr. announced that the agency will pay $1.37 billion to settle an array of government lawsuits that accused S.&P. of inflating subprime mortgage investment ratings.

By Associated Press on Publish Date February 3, 2015. Photo by Kevin Wolf/Associated Press.

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It cost $1.37 billion, but Standard & Poor’s has finally appeared to close the darkest chapter in its 150-year history as a rating agency.

Yet that payout announced on Tuesday, which will settle an array of government lawsuits that accused S.&P. of inflating the ratings of subprime mortgage investments, does not represent closure for the broader ratings business. An uncertain future still lies ahead for S.&P. as well as for its main rivals, Moody’s and Fitch.

In the wake of the financial crisis, when rating agencies were blamed for feeding a subprime mortgage frenzy, Congress used the Dodd-Frank Act to adopt a battery of changes for the rating industry. S.&P., Moody’s and Fitch announced their own cultural overhauls and struck a competitive tone about whose ratings were the strictest.

Eventually, however, that spirit of reform began to collide with the realities of Wall Street.

Despite upstart ventures challenging a ratings oligopoly, S.&P., Moody’s and Fitch still dominate the market. Huge pension funds, some of the same investors that took a beating during the crisis, still consider ratings to be a cornerstone of the financial system. Rating changes, up or down, can still move markets.

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Standard & Poor’s agreed to pay  $1.37 billion to settle suits after being accused of inflating ratings  of mortgage investments.Credit Brendan McDermid/Reuters

At the same time that the ratings agencies have reasserted their influence, some signs of trouble have re-emerged. Last month, for example, S.&P. settled accusations from the Securities and Exchange Commission that it had misled the public about its approach to rating certain commercial mortgage investments — misconduct that occurred in 2011, years after the crisis. And even as S.&P. has publicly raised concerns about the quality of loans backing subprime auto bonds, it continues to award top ratings to the investments, echoing problems that led to the government settlements on Tuesday.

“The $1.37 billion fine shows that the current system does not work,” said Representative Brad Sherman, a California Democrat who has co-written legislation to crack down on rating agencies.

At the heart of the problem, some lawmakers say, is the rating agency business model. The agencies are paid by the same banks and companies they rate. And when market share declines, a rating agency might lower its standards to attract new business, a concern that underpinned the Justice Department lawsuit that S.&P. settled on Tuesday.

“In reality, the ratings were affected by significant conflicts of interest, and S.&P. was driven by its desire for increased profits and market share to favor the interests of issuers over investors,” Attorney General Eric H. Holder Jr. said at a news conference announcing the settlement.

S.&P. argues that its ratings offer investors a valuable service. While certain ratings might prove to be imperfect, they are meant to be opinions, not fact.

But Senator Al Franken, a Minnesota Democrat who has proposed an overhaul of the ratings business, argues that potential conflicts might impair those opinions.

“As I’ve said since the financial crisis, enforcement after wrongdoing won’t be enough,” Mr. Franken said in a statement on Tuesday, referring to the settlement. He called on the S.E.C. to “fix the fundamental problems of the credit ratings agencies’ conflicts of interest that continue to put everyday Americans and our financial system at risk.”

During the debate over Dodd-Frank, Mr. Franken and Mr. Sherman proposed an amendment that would install an independent panel to assign bonds to a rating agency, providing a check on potential conflicts. Ultimately, Dodd-Frank required the S.E.C. to study the issue. Beyond the study, the agency did not take further action.

It did, however, establish a specialized office of credit ratings that conducts annual exams of the companies. Under Dodd-Frank, the S.E.C. also imposed a number of new checks on conflicts of interest.

For example, it prevents a rating agency from allowing employees who help conduct a rating to also participate “in sales or marketing.” That step, akin to a newspaper dividing its reporters from its advertising staff, seeks to draw a line between ratings experts and those who pitch business.

The S.E.C. also mandated a “look-back” review, which requires rating agencies to determine, upon the departure of an employee, whether “the prospect of future employment” by a bank enticed the employee to alter a rating.

Those checks, while modest compared with the proposal by Mr. Franken and Mr. Sherman, represent a significant departure for rating agencies. Until 2007, rating agencies were not formally regulated at all.

Facing this scrutiny, many large investors have heeded the lessons of the crisis, and now say they rely less on rating agencies. But overseas investors, as well as pension funds that manage money for public employees like teachers and police officers, still rely on ratings to pick bonds.

With a spotlight trained on the industry, rating agencies have voluntarily adopted their own reform measures.

S.&P., for example, hired new compliance officers. That department now has more than 50 employees, up from 15 in 2006. The rating agency also invested in technology to improve its rating methods and mandated additional compliance training for employees. For the first time, it also began tying performance reviews — and thus bonuses — to an employee’s compliance with company rules.

More broadly, in the crisis, all of the ratings agencies rewrote the criteria they used for bonds holding pools of loans. These changes generally made it harder for the investments to win top ratings.

S.&P. made particularly aggressive changes to toughen its ratings, bringing in new executives to oversee the process. But those modifications led to a decline in the number of banks choosing S.&P. to grade their investments.

Ultimately, S.&P. replaced an employee who had sought to tighten ratings criteria. Citing that employee’s departure, a 2013 lawsuit from the California attorney general argued that “S.&P. refuses to change its ways.”

The S.EC.’s recent case against S.&P. captured this resistance. According to the S.E.C., S.&P. was losing market share in rating commercial mortgage investments. So it switched criteria, somewhat loosening standards. The change, which once again let the firm recapture business, was not disclosed to investors.

The S.E.C. also cited S.&P. for internal control “failures” in monitoring ratings of home mortgage securities. The breakdowns came from October 2012 to June 2014, years after the crisis.

That case, coupled with the $1.37 billion settlement announced on Tuesday, might eventually serve as a deterrent to future misdeeds. The penalty is high enough to wipe out the rating agency’s operating profit for an entire year.

But the government did not require S.&P. to admit wrongdoing. That sort of admission could have unleashed a flood of additional lawsuits, a real threat to the rating agency’s future.

Heated Path to S.&P.’s Settlement With Prosecutors

Heated Path to S.&P.’s Settlement With Prosecutors

An overflow crowd of government regulators spent a day last month ticking off their demands before eventually negotiating a $1.37 billion settlement of an array of lawsuits against S.&P.