It turns out that the Justice Department is not only concerned with Standard and Poor’s but the entire credit rating agency industry, it appears. The reported investigation into the ratings of mortgage backed securities during the housing bubble is centered on S&P, but not limited to them:
The probe by lawyers in the Justice Department’s civil division appears to be centered on the actions of S&P, though that could change as the investigation proceeds, this person said.
The SEC for months has been looking closely at the conduct of S&P and reviewing the role played by Moody’s Investors Service, owned by Moody’s Corp., in relation to at least two mortgage-bond deals, according to people familiar with the matter.
SEC officials are focusing on whether some rating firms committed fraud by failing to do enough research to adequately assess and rate pools of subprime mortgages and other loans packaged into mortgage bonds. An SEC spokesman declined to comment.
Justice Department lawyers have joined that probe, said the U.S. official familiar with the matter, a common move in such sprawling investigations. Their cooperation began before S&P announced on Aug. 5 the downgrade of its rating on long-term U.S. government debt, the official added.
Fitch Ratings, the other of the big three rating agencies, claims that they are “not aware of any government investigations.”
We already have material in the public domain and whistleblowers who have come forward on this, probably enough to convict both Moody’s and S&P. The NYT said this was a civil investigation, although with DoJ involved the prospect of a criminal investigation is there, at least in theory.
The bigger issue is the overhaul of the entire rating agency structure. Sen. Al Franken (D-MN), whose rating agency amendment passed in the Dodd-Frank Act, released this statement yesterday, and pay careful attention to it:
“While I welcome the news that the Justice Department has launched an investigation into S&P, I imagine they’ll conclude what a lot of us have long known: S&P made record profits by knowingly handing out sterling credit ratings to complete junk,” said Sen. Franken. “If the bipartisan provision I authored in the Wall Street reform law is implemented in full it will prevent the inherent conflict of interest currently plaguing our credit rating system and jeopardizing the stability of our markets. Until we rein in the corruption of the credit rating industry, we are just asking for another financial meltdown.”
Sen. Franken’s Restore Integrity Credit Rating Amendment was introduced with Sen. Roger Wicker (R-Miss.) and passed into law with the Wall Street reform bill. Instead of allowing banks to choose which credit rating agencies will rate the quality of their bonds, Sen. Franken’s provision creates a board, overseen by the Securities and Exchange Commission (SEC), which will assign credit rating agencies to issue an initial rating. This would end the inherent conflict of interest in Wall Street’s current pay-to-play credit rating system by preventing agencies from giving away undeserved top ratings to countless sub-par financial products in order to attract business. The SEC is currently studying the issue. The law requires that the SEC implement Sen. Franken’s provision, or a similar alternative, if the study reveals that the conflicts of interest continue to put investors and the public at risk.
I’ve highlighted the key section. The law is pretty clear on this. If conflict if interest is found, the SEC must implement some provision to end the issuer-pays model. The very fact of an investigation proves that conflict of interest still exists. So in theory, the issuer-pays model should be done for.
That’s clearly what Franken is pushing for, and it should be the focus of advocates as well. We cannot have S&P having the ability to hold hostage both the federal government and state and local governments while keeping a clear financial relationship to Wall Street intact. The implications for any meaningful legislation are obvious.