Standard and Poor’s (S&P), the financial research and rating company, has reached multiple penalty settlements with the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ). The settlements concern accusations S&P awarded inflated credit ratings to clients for mortgage investment programs during and after the subprime mortgage bubble.

The settlement with the SEC requires S&P to pay a total of nearly $80 million in awards:

  • $58 million to SEC;
  • $12 million to New York’s attorney general; and
  • $7 million to Massachusetts’ attorney general.

S&P further agreed to forebear rating commercial mortgage investments for one year.

The SEC claimed S&P overstated ratings of eight commercial mortgage-backed bonds (MBBs) deals by purposefully developing loose rating criteria. The SEC also claimed S&P later attempted to legitimize its inflated ratings by publishing false claims that its methodology was conservative enough to withstand severe economic stress comparable to that of the Great Depression.

In a separate settlement with the DOJ over similar claims, S&P agreed to pay nearly $1.4 billion to federal, state and Washington D.C. governments. California’s share of the award is $210 million. The majority is to be distributed to the California State Teachers’ Retirement System (CalSTRS) and the California Public Employees’ Retirement System (CalPERS) for losses on S&P-rated securities.

Financial watchdog tucks tail and abandons post

S&P is one of three major rating agencies registered with the SEC as a Nationally Recognized Statistical and Ratings Organization (NRSRO). As an NRSRO, S&P evaluates and rates investment MBBs to gauge the financial security of the bonds and the creditworthiness of bond issuers. Thus, S&P sets the standard for investment products and provides investors with ratings with which they may safeguard against financial risk, the lynchpin of banking and investment.

The fatal flaw: S&P’s revenue from ratings flows from the very same investment companies whose securities it is paid to rate. This introduces a structural conflict of interest, providing a great incentive for S&P to issue higher ratings. Thus, S&P is accused of neutering its rating standards and granting favorable ratings to underperforming investment products to increase its own revenue and market share value.

If the SEC’s claims are true, S&P’s failure to properly assess investment bonds not only diluted the integrity of the rating process, but also misled investors into pouring funds into subprime MBBs, the catalyst settings off the global economic collapse. When borrowers defaulted en masse and the value of S&P-rated investment bonds plummeted, so too did the financial market and broader economy.

The recent settlements against S&P for these alleged transgressions force the rating agency to pay a costly bill in settlement awards. However, S&P is not facing any penalties from the SEC and none of the company’s administration will be subject to jail time. The SEC will continue its role as a major rating company.

Further, S&P did not admit any liability and continues to defend the strategies behind its misleading rating scheme, though internal employee correspondences verify that S&P employees were aware of the financial risk inflated ratings posed.

Thus, given the accusations, the settlement is a slap on the wrist for the S&P’s complicit role in promoting the unsound investments that led to the financial meltdown.

SEC’s new regulations protect against an encore performance

In response to the deceptively high ratings liberally proffered during the financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) required SEC to release a report on conflict of interest issues in rating agencies and develop new regulations to prevent future abuses.

SEC has since issued new rules aimed to increase transparency during the credit-rating process. The regulations, which went into effect January 1, 2015, require rating agencies such as S&P to:

  • provide records of their internal control policies and rating methodology;
  • prohibit their sales teams from participating in the rating process;
  • review, and revise if needed, ratings for companies that later hire one of the agency’s employees; and
  • file annual reports showing how the agencies monitor ratings, how ratings changed over time and whether evaluated companies eventually defaulted.

If a rating agency violates these rules, the SEC will suspend or revoke the agency’s registration —disciplinary action that may be effective in preventing rating agencies from faltering off course.

However, while the regulations do attempt to keep rating activity under strict surveillance, the regulations do not restructure the way rating agencies solicit business or receive payment, as some rejected amendments proposed.

SEC has thus far failed to maintain control and ensure rating agencies follow proper rating methodologies — the multiple accusations against S&P attest to these failures — but only the health of the future financial market will tell whether the recent regulations will have a long-term stabilizing impact.