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The Department of Justice has filed a $5 Billion lawsuit against S&P claiming fraud in their flawed ratings of sub-prime mortgage-backed securities. Meanwhile many have rushed to their defense. Who's right?

In a curious spate of editorials, several prominent media and Wall Street gurus have risen to the defense of S&P regarding their terribly negligent rating of sub-prime mortgage-backed securities.

In a Feb. 6 editorial, the LA Times asks: “Is the S&P to blame” for providing the unwarranted and high ratings it gave to mortgage-backed securities?  And recently the Chicago Tribune wrote: “The government sues S&P for what? Revenge?”  I believe all such commentaries are not only premature, but have poorly crafted defenses.

The first and least persuasive is that S&P “simply expressed an “opinion” that investors were free to disregard”.  The flaw in that argument is that an “opinion” should not be trivialized. Indeed, the word “opinion” is also used in Supreme Court cases and decisions.  The fact is that an S&P opinion carries enormous weight with investors because there are really only three credible rating agencies, and investors rely on them almost exclusively for the viability of their investments.

The fact that S&P merely gave an “opinion” on these terribly flawed financial instruments cannot minimize the affect it had on the reselling of the securities nor the devastating consequences.  The Department of Justice on February 6 filed a $5 Billion suit regarding S&P’s “opinion” claiming it willfully “disregarded the danger signs and skewed its opinions to serve its own interests”.  Well, that is yet to be decided, however, in coming to the defense of S&P so early, the defenders have suggested the suit is really based on revenge by the Obama administration for the S&P downgrading of the United States debt last year.  By that logic, if some agency or other entity raises question about certain government issues, it would then be given some measure of immunity from legal action because any such action always could be characterized as “revenge”.  In this case there is no evidence of a revengeful motive – the case is based strictly on the merits of S&P’s badly flawed analysis, which the DOJ suspects was related to the fact that the Wall Street firms who created these sub-prime mortgage-backed securities also pay S&P huge fees to evaluate their offerings!  S&P owned by McGraw-Hill, is the company’s most profitable unit. This is a clear conflict of interest, and definitely worthy of investigation by the DOJ.

Some who have rushed to question the suit ask why it is only S&P being investigated and sued?  Well, first, there is the fact that S&P is the largest of the three national rating agencies (Moodys and Fitch being the other two), thus having the greatest volume of flawed decisions. Beyond that, there is the statement by Lisa Madigan, Illinois Attorney General who stated when the suit was filed: “We haven’t closed the door on additional enforcement efforts”. Indeed, both New York and California attorneys general may well widen the investigation.  The cost to investors in California public pensions alone were reported to be over $1 billion. The scale of this malfeasance again suggests merit in pursuing both the facts, and possible ultimate recovery of funds that were often outrageously characterized as “blue chip…No. 1…AAA investments. At the least there was roaring incompetence and/or negligence which contributed to the devastation of the American economy; at worst there was fraud based on the above noted conflict of interest. Either way, some recompense is appropriate through a settlement on the former reason or through a serious penalty if it was indeed fraud.

As a side note, the CEO of McGraw-Hill (parent company of S&P) made $44 million in compensation during the period of the flawed ratings; and the DOJ has so far elected not to make this a criminal case. Also noted, S&P is the most profitable subsidiary of McGraw.

Wall Street fears that this suit may precipitate the demise of the S&P and/or even the end of all three vitally needed credit rating agencies. That is unlikely for several reasons. First, this is a highly lucrative business. Secondly it is one which has little competition. And third, should this be the demise of S&P, there would surely be likely new candidates to accumulate the huge profits S&P has enjoyed in the past. Besides, that alone is no reason to obstruct litigation which clearly has some merit and significant ramifications.

No, the media’s rush to the defense of the rating agencies is both premature, and may also prove to be unwarranted. So, asking the question in the Chicago Tribune: The government sues S&P for what? I would answer…not revenge, but ”fraud”. And to the LA Time’s query: “Is S&P to blame?” my answer would be “Probably”.

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