S&P’s defense in the government’s anti-fraud lawsuit

the lawsuit

According to the Wall Street Journal, both S&P and its parent, McGraw-Hill, have filed responses in federal court in Los Angeles to the Justice Department’s recent civil lawsuit against S&P.  The suit accuses S&P of fraud by giving too-high ratings to mortgage-backed securities that later imploded during the financial crisis.  Among the victims cited are Citibank and Bank of America, who created some of the securities and paid S&P to rate them.

the defenses

McGraw-Hill has two points:

–it can’t have defrauded Citibank and BofA, who were in the kitchen making the toxic messes and knew what they were doing much more intimately than any outsider ever could, and

–other ratings agencies, like Moodys and Fitch, issued identical opinions bu aren’t being charged (of course they didn’t reduce their AAA rating of Treasury bonds, the way S&P did).

S&P has a more humorous defense:

–it points to two prior court rulings that the company’s claims for its ratings–that they are independent and objective–are just subjective opinions that no reasonable person would take seriously.  That casts the claims as sort of like the Kia commercials that have sock puppets or giant rodents piloting company cars through time and space.   Not very flattering–particularly to anyone who claims to have taken the ratings as either independent or objective.

my take

1.  We all know as a matter of principle that there’s no free lunch–anywhere.  Yet, every few years salesmen of financial products tout some new “miracle” of financial engineering that subtracts the risk from risky investments, leaving only super-high returns.  Bernie Madoff is an extreme example.  But junk bonds were originally marketed as having all the rewards of stocks but with the safety of bonds.  In the early 1990s, short-term European bond funds were sold as being “just like” domestic money market funds, but with 3x the yield.

When these products implode, as they invariably do, the most common reaction is not to blame one’s own bad judgment, but to point a finger at the seller of the product.   Or in this case, to the seller’s front man.

2.  In the case of professional investors, it’s inconceivable to me that any buyer relied on S&P ratings as the sole, or even one of several, important reasons for purchasing a security.  At best, the rating is a gross screening factor (bad rating = don’t buy).  Everyone is aware that S&P is paid by the issuer of the securities it rates, and that it only gets paid if the rating is high enough to let the offering take place.

Every buy-side credit analyst knows he’s a lot better than anyone at S&P.  And the buy side knows that, unlike S&P, it has to live with the consequences of its buy decisions.  While it’s easy to blame S&P when an investment goes wrong, the real fault lies with the independent credit analysis done by the buyer.

3.   Why choose a bit player like S&P to sue?   …why not the banks who issued the toxic securities?

Other than the army, I’ve never worked for the government, so I have no special insight into the Justice Department’s mindset.

My guess is that S&P is the easiest for someone who has no practical experience in financial markets to understand.  The case itself is modest in scope.   It may not raise the thorny issues of how regulators could have been so deeply asleep at the switch, or why laws were changed in the 1990s to permit banks to brew their toxic concoctions.  And of possible targets, S&P likely has the fewest political and financial resources to defend itself with.

If the WSJ is correct, though, part of S&P’s defense is that the government has already lost this case once before.  Odd.