We all know that you shouldn’t pick a fight with someone stronger than you. Apparently, no one chose to tell Standard and Poor’s (S&P). The ratings agency, which recently downgraded the American government’s debt rating, is now being investigated by the Justice Department for its role in the mortgage-backed securities bonanza.
While the New York Times is reporting that the investigation was started before the downgrade, it is noteworthy that the investigation is not thought to be looking into Moody’s or Fitch, the other major credit rating agencies. And although the investigation reportedly started before the downgrade, it is curious that it is only being reported now.
The investigation is focused on the ratings S&P gave to mortgage-backed securities (MBS), many of which were backed by sub-prime mortgages. S&P gave a AAA rating to many MBS’s, the agency’s highest rating and one that the Government enjoyed until recently. So how could a pool of sub-prime junk mortgages ever have the same AAA rating as a US Treasury bond?
Of course, it was based on such ratings that many investors chose to invest in these securities.
The problem: the ratings agencies, Moody’s and Fitch included, get paid by banks to rate their securities.A conflict of interest emerges because the agencies rely on the fees generated by the reviews and so are tempted to give securities a higher rating to keep the banks’ business.
It’s like a restaurant critic getting paid by a restaurant to review its food.
The investigation is looking into allegations that ratings analysts wanted to give certain securities lower ratings than they got but were overruled by business managers concerned about the bottom line. The managers presided over record profits during the housing boom when many failed securities were first given their high ratings.