Bates Research - 02-06-15

S&P Settles DOJ Claim

On Tuesday, S&P finally settled a long-standing matter with the DOJ and various other entities. The final settlement value was close to the one we put forward in our previous post about the settlement reached between S&P and the SEC: a total of $1.375 billion with $687.5 million going to both the DOJ and various state claimants. A related $125 million settlement was also reached with CalPERS.

The case was brought forward exactly two years prior to the day it was settled, and it relates to S&P's rating activity in the MBS and CDO marketspace from 2004-2007. Publicly, S&P presented its ratings as independent and impartial for the use of investors in determining the riskiness of various fixed income products. Contrary to that appearance, many conflicts of interest were uncovered in which S&P weakened, adjusted or delayed changes to its rating criteria in order to avoid losing market share (and profits) to other rating agencies. S&P's own analysts warned the company that many of these actions would lead to final ratings being issued that did not reflect the actual credit quality of the rated investment.

We've blogged previously about the record-breaking fines levied against various financial institutions, and the S&P settlement isn't even the high watermark of MBS/CDO settlements for DOJ, which reached as high as $17 billion last year. In settling the suit, S&P neither admitted nor denied fault, something which will be key as other parties decide whether or not to separately sue the company.

More interesting twists are being revealed as reporters have begun digging into the settlement itself. The source of conflict between S&P and the U.S. government seems to stem back to August 2011, when S&P was the lone rating agency that downgraded U.S. debt. In a sworn affidavit filed in the U.S. District Court, Central District of California, Southern Division, Chairman Harold W. McGraw III of McGraw Hill Financial Inc. (which owns S&P) stated that then Treasury Secretary Tim Geithner called him and told him that "S&P’s conduct would be looked at very carefully...such behavior would not occur, without a response from the government."

The WSJ provides a great timeline of the negotiations between both sides. The first proposed settlement numbers came back in February 2014, with the government proposing $3.2 billion. S&P took until November 2014 to counter, with an offer of $750 million to resolve the suit plus CalPERS claims. A month later the government came back at $1.9 billion, not including the CalPERS claims, plus an admission of wrongdoing by S&P.

Eventually the two sides drilled down to the final figure of $1.375 billion, with the DOJ requesting that the political retaliation argument be dropped by S&P, and S&P requesting that the settlement not include an admission of wrong doing.

Critics of the settlement were quick to point out that the government's action does little to address the conflicts of interest that caused the breakdown in the first place - namely, that raters are paid by the issuers, rather than the users, of their credit ratings. Senator Al Franken (D-MN) has been a noted critic of the rating agencies, and issued a statement encouraging the government to move beyond enforcement and towards prevention. His words carry particular weight as he was partially responsible for the Franken-Sherman amendment to the Dodd-Frank act, which required the SEC to create a nonprofit board that would assign credit rating agencies to those seeking ratings, avoiding the conflict of interest in "rating shopping" present today. The language was modified in the final version to give the SEC two years to implement its own alternative idea, with the nonprofit board automatically going into effect after that time period. That two-year period has passed, and the SEC has been relying on another provision which allowed it to avoid implementing the program if it found that conflicts of interest were not leading to deceptive ratings. While S&P did not admit any wrongdoing in this settlement, the SEC will probably face renewed pressure to adopt Franken-Sherman or to come up with an alternate proposal to safeguard against future conflicts in the rating business.


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