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Bates Research  |  01-23-15

S&P Settles with SEC

On Wednesday, S&P reached a settlement with the SEC over allegations of fraudulent misconduct in its rating procedures. This ends an investigation that initially began in July of last year, when S&P received a Wells Notice from the SEC related to six commercial mortgage backed securities transactions that it had pulled ratings on.

The deal in question was a joint placement of $1.48 billion in commercial MBS by Goldman Sachs and Citigroup. S&P provided ratings support, and the deal was placed with investors, only to have S&P say that it would not be able to deliver final ratings mere hours before the deal was to settle. S&P claimed that it had discovered an inconsistency in its model (related to debt service coverage ratios) that needed to be resolved before it could provide any additional ratings to the market. After staying out of the commercial MBS market for over a year, S&P announced in August 2012 that it would resume rating coverage using a new model.

The SEC found that S&P had changed its method for calculating debt service coverage ratios, which directly impacted the amount of credit enhancement necessary to support certain ratings. From February 2011 to July 2011, S&P's published reports failed to disclose this change. During their investigation, they also found that S&P did not adhere to published criteria for estimating loss severity in seasoned (issued prior to 2009) residential MBS. Finally, it found that an article proposing a way to estimate possible loan losses in the commercial MBS market during times of extreme stress was generated using unsound methodologies.

As a result of S&P's "deep cultural failure," they will pay $58 million to the SEC and $12 and $9 million to settle similar claims with the Attorney Generals of New York and Massachusetts, respectively. Perhaps more notably, S&P will also be suspended from providing commercial MBS ratings for one year.

S&P is still facing a $5 billion lawsuit brought by the Department of Justice in connection with its activities in rating subprime mortgage backed investments. The suit alleges that S&P eased its rating criteria as a way to compete for business in the lucrative market for rating these securities. The settlement of the SEC investigation may be a precursor to a settlement in this larger suit, where S&P is expected to pay $1.4 billion to settle with the DOJ and 20 states (including the District of Columbia).

The phenomenon known as "rating shopping," in which issuers played the various rating agencies against one another in order to secure the best possible rating for their securities, was widely blamed as a precipitating factor in the credit crisis. Investors claimed that they relied on the rating agencies to provide solid guidance on the risks of various investments, but the rating agencies themselves were actually engaged in a so-called "race to the bottom," in order to capture more of the fee revenue generated by rating MBS. This conflict of interest created a substantial amount of scrutiny among various regulators, whose investigations are now beginning to be resolved.