Credit where itís due

Why, irrespective of the outcome, the US government's lawsuit against Standard & Poor's is good for the credit ratings industry

After years of speculation, the United States department of justice filed a lawsuit against Standard & Poor's, the world's largest credit rating agency, to the tune of $5 billion last week. The 128-page document places the actions of S&P front and centre in the events of 2008 that brought down the market for residential mortgage-backed securities, leading to the global financial crisis. According to the justice department, S&P is liable for such a large fine because it "knowingly, and with the intent to defraud, devised, participated in and executed a scheme to defraud investors"ó those market participants who relied on its credit ratings to guide their investment decisions.

To date, the rating agencies have largely avoided accountability for their role in the financial crisis through a combination of favourable legal precedent and timidity by the authorities. But recent judicial decisions in the US suggest that the defences successfully relied upon by rating agencies in the past, including the freedom of the press under the First Amendment, may be less effective going forward. The lawsuit is anything but timid. These developments bode well for the future of the credit ratings industry and thus for financial markets throughout the world.

To understand how the S&P lawsuit will improve the credit rating industry, let's go back to basics. A credit ratings agency is a group of financial analysts and journalists who evaluate the quality of the debt issued by governments and firms. They come up with a credit rating that summarises how likely the entity is to pay back what it borrows. Both Moody's and Poor's (which later merged with Standard Statistics to form S&P) got their start by selling information to investors. In the 1970s, however, the industry shifted its business model towards borrowers, charging them a fee for each security they rated. S&P's defence will be based on this change: it merely disseminated opinions that issuers sought; investors did not pay them and were not bound to adhere to their opinions.

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