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.

The role of the credit rating agencies in the financial crisis stemmed from the proliferation of new securities backed by residential mortgages during the 2000s. Take a bunch of housing loans, put them in a glass, and shake. Just as mixing sand and gravel with water in a middle school science experiment produces clear layers after the pieces settle down, the new housing loan instruments had layers called tranches, defined by the probability of their being paid back. Slicing tranches from different securities and shaking them together produced even more complex instruments. Because these new securities were often formed through complicated combinations of thousands of individual residential loans, assessing their creditworthiness was no small task. Yet, credit rating agencies were happy to provide favourable ratings to the new instruments.

The fundamental flaw in this rapidly growing market was that, as securities became more complex, the acquisition of information by private investors became increasingly costly, causing greater reliance on credit rating agency assessments. With a burgeoning market for mortgage-backed securities, demand by institutional investors for top-rated securities outstripping supply, and the agencies being paid for every rating they handed out to the issuers (whether accurate or not), the incentives all around were severely skewed. Credit rating agencies had an incentive to provide favourable ratings to securities, lest they lost business. There is enough evidence to join the dots and conclude that credit rating agencies fuelled the crisis.. The question though remains, should they be liable?

The government has its work cut out to win the lawsuit. In particular, it must show (among other things) that S&P intentionally deceived investors about its credit-rating process; that is, that it promised investors the process was objective, while secretly analysing the securities' creditworthiness with an eye towards its own profit. The evidence offered so far suggests the government has some hope of proving the claim. Most striking are internal communications in which employees voiced concern that the company was allowing improper financial incentives to cloud what was supposed to be an unbiased analysis. S&P has responded that the government's evidence is taken out of context, and at this point it is simply too soon to know who is right.

But whether or not the government wins its case against S&P, its decision to file the lawsuit creates a win-win scenario for the functioning of the credit ratings industry. On the one hand, the misaligned incentives generated by the rating agencies' business model were no secret before the lawsuit. A victory for S&P could restore investors' shaken confidence in the analysis underlying its ratings.

If, instead, the government is victorious, investors will be able to rest more easily when relying on a company's credit ratings. Credit rating companies have always tried to assuage investor concerns about misaligned incentives by promising that the credit-rating process is objective and unclouded by improper concerns. Lawsuits like this one force a rating company to put its money where its mouth is; signalling the government's willingness to intervene when a credit agency promises unbiased analysis but does not deliver. Put differently, it tacks a steep price onto what could otherwise be cheap talk.

Goldin is a research scholar at the department of economics at Princeton and is studying law at Yale. Lamba is a research scholar in economics at Princeton and an economist at the office of the chief economic advisor, Union ministry of finance

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