Standard & Poor's is poised to settle a major Securities and Exchange Commission investigation of ratings of securities in the commercial-mortgage bond market. The SEC will exact a severe punishment: a yearlong suspension from grading securities backed by multiple commercial loans, according to Bloomberg News. But wait, there's more: S&P has yet other problems with the government that will likely require costly settlements and raise additional questions about the credit rater's credibility. Here's what you need to know:
What's going on right now? The SEC notified S&P in July that investigators were snooping around commercial mortgage-backed securities (CMBS) from 2011. The alleged violations were related to S&P's evaluations of the securities and "public disclosure made by S&P regarding those ratings," according to a regulatory filing by S&P's parent, McGraw Hill Financial. In plain English, that means the SEC suspected that S&P monkeyed around with its criteria to win additional business from issuers. The incipient deal to resolve those allegations, which Bloomberg News said may be announced as soon as Wednesday, would ban S&P from a significant portion of the CMBS market for a year. That would amount to the regulator's toughest enforcement action in recent memory against a credit-rating company. Spokespeople for S&P and the SEC declined to comment, according to Bloomberg News.
Why does this matter? S&P will lose a boatload of fees while its analysts sit on their hands. New York-based S&P's competitors—Moody's Investors Service, Fitch Ratings, and the upstart Kroll Bond Rating Agency—will all benefit in the short run by grabbing business S&P has to surrender. One has to wonder whether, at some point, the repeated questions raised about S&P's credibility will erode the largest credit-rating company's leading position in the marketplace. I mean, even if S&P hasn't committed fraud, as the government has alleged, doesn't its apparent incompetence eventually catch up with the organization? (By the way, on the CMBS matter, the attorneys general of New York and Massachusetts are also reportedly investigating S&P.)
What's that about alleged fraud? Earlier this month, the proverbial people familiar with the matter murmured that S&P is close to a separate settlement of about $1 billion with the Justice Department. That deal would address allegations that the company misled investors about ratings of residential (as opposed to commercial) mortgage-backed securities before the 2008 subprime-driven Wall Street crisis. S&P, the only credit rater targeted by the feds in this manner, once again was accused of going easy in grading securities and concealing conflicts of interest to win the affection of banks that issue the investment vehicles. The Justice Department has denied S&P's complaint that it was singled out by the Obama administration because of its downgrade of U.S. debt in 2011. The government sought as much as $5 billion in civil penalties in this case, and a trial is tentatively scheduled for September.
And what did deal-structuring cows have to do with all this? In one of the most notorious e-mails to surface from the 2008 financial crisis, an S&P analyst told a co-worker that investments could be "structured by cows" and still get rated favorably. The e-mail became a symbol of laxity at S&P and throughout the ratings business. After all, the implosion of mortgage-backed securities rubber-stamped with "AAA" ratings helped set off the Wall Street credit crisis and a near-depression. While denying fraud or any kind of civil liability, S&P has apologized repeatedly for failing "to fully anticipate the rapidly deteriorating conditions in the U.S. mortgage market during that tumultuous time," as a spokesperson once phrased it to me. But isn't that exactly what a rating agency is supposed to do: anticipate changing conditions to protect investors?
