In February 2015, S&P agreed to pay $1.5 billion in a settlement with the U.S. Justice Department and more than a dozen states over its ratings of mortgage-backed securities before the subprime crisis. The month before, it had reached a settlement with the U.S. Securities and Exchange Commission and the states of New York and Massachusetts under which the company would be suspended for a year from rating securities in the biggest piece of the commercial-mortgage bond market and pay $80 million in fines. Regulators said S&P had set aside its usual methodology to win business in that market in 2011. The subprime suits were helped by e-mails like one from an S&P employee saying, “Let’s hope we are all wealthy and retired by the time this house of cards falters.” S&P charged that it was being unfairly singled out by federal prosecutors in retaliation for cutting the nation’s AAA grade in August 2011, but admitted in the settlement that it had no evidence to back that up. The 2011 downgrade had been ignored by the markets, as are many calls on government debt by all of the raters, including their downgrades of Japan and Italy in December 2014, just as investors had deemed the U.S. a better bet after S&P’s downgrade. One analysis found that since 1970, rating changes on sovereign debt have been ignored as often as followed. But studies by regulators in the U.S. and Europe found the big three raters hanging on to their dominant position.
Often called “agencies,” raters are actually profit-seeking companies. John Moody, a former journalist, helped start the business in 1909 by issuing letter grades to rank the ability of railroad companies to repay loans. Ratings became so widely used that in 1936 the U.S. Comptroller of the Currency banned banks from holding bonds not rated investment grade. The SEC further weaved Moody’s, S&P and Fitch into the regulatory fabric in 1975 by naming them “Nationally Recognized Statistical Rating Organizations” and requiring investors in some circumstances to buy only bonds with their seal of approval. That led to lower borrowing costs for many companies and municipalities, since investors could think they had expert guidance to rely on. Today, though, ratings upgrades don’t necessarily translate into lower yields, or downgrades into higher ones. That’s because professional investors usually have priced in the moves well before they happen, leaving raters in the position of catching up to the market. Ratings do matter more in markets that are complex or thinly traded — exactly the kind that blew up in 2008. To prevent a repeat, the SEC has set up a new office of credit ratings that reviews the companies’ methodologies annually.
In August 2014, the U.S. Securities and Exchange Commission voted 3-2 to impose new restrictions on conflicts of interest, but critics say those steps don’t go far enough or address the central conflict of interest: The rating companies are paid by the issuers whose bonds they’re evaluating. The rules include a strict prohibition on allowing sales motives to influence ratings. The European Union is experimenting with a requirement that companies issuing bonds use different raters, in a rotation. The SEC hoped to promote competition in a market where the top three companies won 95 percent of sales in the U.S. in 2012, and as much as 90 percent globally. In 2014, those numbers had crept up slightly. Even where competition has increased, one problem is that more companies mean more options for Wall Street to shop around for top grades. Shifts in market share can also prompt loosening of standards: S&P revised its methods for assessing corporate debt after falling behind in that field. Many critics think the best reform would be to erase raters from regulations altogether, leaving investors to do their own analysis.
The Reference Shelf
- Bloomberg News article on Wall Street shopping for the best credit ratings.
- Primer of the history of credit ratings by New York University Professor Richard Sylla.
- The Securities and Exchange Commission’s annual report on the state of the credit ratings business.
- The U.S. Justice Department’s lawsuit against S&P.
- National Bureau of Economic Research paper by Efraim Benmelech of the Kellogg School of Management and Jennifer Dlugosz of the Olin Business School on the role of credit rating agencies in the 2008 financial crisis.