The Justice Department’s lawsuit against Standard & Poor’s this week has revived focus on the role of the rating agencies in causing the financial crisis. Yet four years after shoddy mortgage investments bearing top grades nearly took down the country’s economy, government attempts to revamp the rating-agency industry have stalled.
Nearly everyone agrees there needs to be an overhaul of the way complex financial products get rated for their riskiness. But attempts to change the system keep running into the same roadblock: The rating agencies, however flawed, have become so crucial to the workings of Wall Street that no one can live without them.
Experts say that the Justice Department lawsuit is not enough — and that the longer the government delays broad solutions, the more vulnerable the economy is to the risks that took it down in 2008.
The lawsuit “may help the government appear to be dealing with the problem and holding the S&P to account, but that isn’t dealing with the core problems,” said Jeffrey Manns, associate professor of law at George Washington University.
The key issue, identified by two major government reports on the crisis, is that rating agencies are paid by the very companies whose products they are grading. Watchdogs argue that the agencies’ dependence on Wall Street means they tend to award better grades to products even if they have reason to doubt their safety.
The Justice Department’s lawsuit centers on this point: Government attorneys allege that S&P deliberately misled investors by giving higher grades to products that it knew had serious problems — out of fear of losing business from banks.
S&P, which has called the lawsuit baseless, said in a statement this week that it has invested about $400 million to improve how it rates securities. This includes rotating analysts assigned to particular banks in order to reduce possible bias. The company argues that it has “long had policies in place to manage potential conflicts of interest.”
The Dodd-Frank financial regulatory law tries to address problems with the rating-agency system in a few ways, though two of the statutes have been stymied.
The most ambitious is an amendment from Sen. Al Franken (D-Minn.) that seeks to resolve the conflict-of-interest problem. The amendment asks the Securities and Exchange Commission to consider creating an independent board that would assign rating agencies to structured financial products. Currently banks can pick and choose which agency they want to use.
The SEC released a report on the amendment last year, as mandated by the law, and is organizing a roundtable to discuss it further. The agency has the authority to implement the law but has not done so yet.
“Continued consideration of this issue is one of several steps we are taking to increase transparency, reduce conflicts and promote ratings with integrity,” said John Nester, an SEC spokesman.
Another section of Dodd-Frank would have given investors more power to sue rating agencies if the companies’ assessments turned out to be wrong. Under the law, rating agencies would become liable for any misleading rating included in an SEC filing — much the way lawyers and accountants can be sued if the information they provide is wrong.
But this, too, has not worked as expected.
The rating agencies balked, saying they would no longer rate the securities.
“There was a real threat the markets would grind to a halt,” said Scott Kimpel, a partner at Hunton & Williams and former counsel to SEC Commissioner Troy Paredes.
Companies have been required by law since 2004 to disclose credit ratings of certain complex securities. But in November 2010, the SEC said they would not go after any company that did not disclose ratings of these complex securities. This, in effect, has allowed the rating agencies to skirt the potential for lawsuits from the Dodd-Frank rule.
Dodd-Frank also mandated that rating agencies provide more information in their analysis so investors can have more information to make better decisions. This part has been largely implemented.
Manns, the law professor, said this step was probably the easiest to put in place. “That’s a step for progress,” he said.
The trouble in dealing with the rating firms is that while there is broad consensus about the problems, there is little agreement on how to address them.
“It’s not like there’s a silver bullet sitting out there that we can go and use and solve the problem,” Manns said.