Is the SEC Finally Taking Serious Aim at the Ratings Agencies?

If the grumblings in the comments section are any guide, quite a few citizens are perplexed and frustrated that the ratings agencies have suffered virtually no pain despite being one of the major points of failure that helped precipitate the global financial crisis. If there were no such thing as ratings agencies (i.e., investors had to make their own judgments) or the ratings agencies had managed not to be so recklessly incompetent, it’s pretty unlikely that highly leveraged financial institutions would have loaded up on manufactured AAA CDOs for bonus gaming purposes.

But the assumption has been that the ratings agencies are bullet proof. Their role is enshrined in numerous regulations and products that make ratings part of an investment decision. And they get a free pass on mistakes, no matter how egregious. (Note that there have been rulings that have taken issue with the ratings agencies reliance on the invocation of the First Amendment defense, but to date they have been on procedural matters. To my knowledge, no party has been awarded damages against a ratings agency based on a judge deciding that a First Amendment defense was inapplicable)

So why, pray tell, has the SEC sent a Wells notice to Standard and Poors, which is a heads up that the regulator may file civil charges, which could result in penalties and disgorgement of fees, on a 2007 Magnetar CDO called Delphinius? The history is that suing ratings agencies over their opinions has not been a terribly successful exercise. And the SEC tends to be conservative in the cases it files; it likes to have a high certainty of a win, whether that means a courtroom victory or a reasonably fast settlement.

A cynic might say that this action is politically motivated, a punishment for the S&P having crossed Uncle Sam by downgrading US debt. Maybe, but a Wells notice is not a suit, and a Wells notice that does not lead to a court filing may raise questions about what the SEC is up to.

My guess is that the SEC thinks it has a shot at a new legal argument that might fly given the particularly rancid conduct of S&P in the Delphinius deal. Per Bloomberg:

Delphinus was highlighted in a U.S. Senate panel’s report as a “striking example” of how banks and ratings firms branded mortgage-linked products safe even as the housing market worsened in 2007. S&P rated six tranches of Delphinus AAA in August 2007 and began downgrading the securities by the end of the year, according to the Permanent Subcommittee on Investigations report released in April. By the end of 2008, they were rated as junk, according to the report….

In e-mails released by the Senate investigations panel led by Michigan Democrat Carl Levin, some S&P analysts questioned whether the Delphinus bonds deserved top grades. The analysts said the securities backing the deal were different from what bankers had described, according to the report.

“Um … looks like the remaining portion is actually all sub-prime,” one analyst wrote.

“Do you want to address this with them, or let it go?” another replied

The Wall Street Journal clarifies this issue a tad: the deal structure provided for “dummy assets” that were assumed to be of a certain quality. The final transaction has assets that were markedly worse. And the S&P knew about it.

The reason this might make a difference is First Amendment defenses are based on the notion that the journalist acted in a good faith manner with a concern for accuracy. If a media outlet publishes an article that is recklessly inaccurate or with the intent to harm, the First Amendment shield is inoperative.

The question here thus is whether making a rating that was obviously inaccurate, given what S&P knew about the deal, is sufficient grounds for arguing that the rating agency acted in bad faith. Other actions around that time could bolster that argument. This CDO was one of the very last ones issued, right as the bottom was dropping out of the subprime market.

he next most unusual thing about the deal is that it was issued in late July, in 2007. On July 10th of that year, S&P downgraded over 600 subordinated subprime MBS bonds from deals issued between 2005 and the end of 2006, which shook the markets that summer. As we have noted before, it was not credible to have downgraded subprime bonds and not have simultaneously downdgraded CDOs made substantially of exposures to the very same bonds. To put it politely, S&P had to engage in some meaningful denial to analyze the deal in a way that ignored the downgrades of so many earlier vintage subprime MBS.

Even our assessment is right and the SEC has a decent shot at making a case, S&P is sure to fight a scorched-earth battle, since maintaining the First Amendment defense (particularly with regard to subprime-related deals) is a life-or-death issue. But some open questions remain:

It is likely Moody’s rated this deal as well. So why is S&P being singled out? It may be that the Levin report uncovered suspect conduct from S&P on this deal and not Moodys, but the two firms would presumably have taken the same position on the dummy assets if they issued similar ratings.

In October, 2007, S&P downgraded hundreds of subprime bonds backed by deals issued from January 1st to June 30th of 2007 Given the late closing date of this deal, and the big impact of the S&P MBS downgrades (followed a few days later by Moody’s downgrades of several billion of MBS), this deal is unlikely to have had any outside investors, since the market froze pretty quickly (IKB is possible, since they blew up roughly three weeks later). It thus may be if the originators wound up holding the bag, the damage to third parties was limited, and therefore there would not be a basis for arguing damages.

S&P is certain not to settle were a suit to be filed. They can’t afford to lose, but they also can’t afford to make an admission of vulnerability. They would fight it just as vigorously as rating agencies have past legal actions.

Even though this would be an uphill battle for the SEC, I’d like to see this Wells notice lead to a lawsuit. Too many people have gotten away with way too much in the crisis. It’s time to start meting out some justice.

Update 4:00 AM: I just saw the New York Times story on the Wells notice. This part is funny:

There was so much demand for the Delphinus 2007-1 deal in July 2007 that Mizuho Securities increased its size from $1.2 billion to $1.6 billion, according to a Mizuho news release. The bank’s head of structured credit for the Americas said in that release that investors wanted “better quality collateral.”

Translation: “We knew the window was closing fast, so we shoved as much crap into this puppy as we could and tried to pretend that investors made us do it.”


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  1. psychohistorian

    When I hear about a few in jail then I will HOPE that justice has a chance…..until then, not so much.

    But thanks again for your untiring efforts.

  2. jake chase

    I have been watching the SEC for signs of intelligent life since I worked there in 1968. There haven’t been any. It is all public relations, strong arm operations against small businesses desperate to raise money and bewildered by idiotic regulations, and toadying up to major league financial predators by fat assed bureaucrats plotting their next career move. You might as well expect law enforcement from the Department of Agriculture.

    1. Johnny Clamboat

      If only the right people were in charge…..

      I really thought Mary Schapiro was one of the right people.


  3. rf

    Although rating agencies received fees for rating the structures and investors knew this it seems the importance of the conflict was lost on the investor. Maybe more clarity on the fee earned and the size of the relationship across all deals with the underwriter would have helped and would help in the future to the extent that one pays attention to ratings at all. Or maybe not, maybe there’s too many investors not doing any homework and depending on the agencies no matter the disclosure… Either way the reason this conversation:

    “Um … looks like the remaining portion is actually all sub-prime,” one analyst wrote.

    “Do you want to address this with them, or let it go?” another replied

    happened was because the underwriter was S&P’s customer.

    1. Zugswang

      If ratings agencies can hide behind the first amendment, then I believe it logically follows that doctors should be immune from malpractice suits. I mean, it’s only their medical opinion, right?

      1. decora

        and, as Yves alludes to, journalists should be immune from defamation suits as well as invasion of privacy suits and Espionage Act suits.

        besides, there’s no first amendment in the UK or Australia, so why don’t some investors from those companies sue the ratings agencies?

  4. James Cole

    I’ve always thought the first amendment defense would not stand the first investor suit with good facts (good facts for the plaintiff-investor’s case). The first amendment was invoked by the rating agencies when they were first sued by local governments who were upset with lower-than-expected municipal bond ratings–the governmental units were not seen as having the power to “suppress” the “free speech” of the rating agencies. But vis-a-vis investors, there should be no first amendment issue as the first amendment does not protect fraudulent speech.

    1. Procopius

      IANAL, but I have read in a number of places (ECONned was one such place) that accountants and lawyers are also exempt from responsibility in cases of commercial fraud, based on their certifications being only “opinion,” protected by the First Amendment. I thought Sarbanes-Oxley was supposed to fix that, but apparently not. Or maybe the situation is fraught with technicalities that I don’t grasp (entirely possible).

  5. vtek

    the ratings agencies are a symptom of the problem and i’m reluctant to give them more blame. that they did their jobs poorly or that there are huge independence problems surrounding them is not up for debate, but here it seems that they are being used as a scapegoat for lazy and damaging regulation. agencies like the sec and equivalents all over the world force the companies they oversee to use accepted ratings agency ratings for their stress tests, and as a result, all alm is based on agency ratings rather than investor due diligence. if it wasn’t for the regulatory need for companies to follow s&p/moody’s/a&m best/fitch ratings, many more would do the analysis themselves. this is sadly an area where no flawless solutions exist, although clearly better independence rules need to be adopted.

  6. Barbara Roper

    Since passage of the Credit Rating Agency Reform Act of 2006 (CRARA), the SEC has had enforcement authority for violations that isn’t subject to the same First Amendment limitations that private lawsuits face. (That authority was strengthened and expanded in Dodd-Frank, but it would not apply retroactively.) The most serious remaining restriction on SEC authority is that it is prohibited from regulating the rating agencies’ methodologies. Assuming the SEC’s case is based on a violation of CRARA, I would expect S&P’s main defense to be that the SEC is attempting to regulate its methodology. If the SEC can show that S&P violated its own methodology, they might have a decent chance of prevailing. Both the SEC’s credit rating agency study and the Senate Permanent Subcommittee report are rife with examples of the rating agencies apparently ignoring their own procedures and methodologies, so maybe there’s still a chance that they will be held accountable.

    1. ReaderOfTeaLeaves

      The FCIC hearings on ratings agencies were shocking.
      If the SEC can’t successfully prosecute, the agency should be abolished ASAP.

  7. F. Beard

    Their role is enshrined in numerous regulations and products that make ratings part of an investment decision. Yves Smith

    Sounds like fascism to me – government privilege for private interests. And all created with the best of intentions, I’d hazard.

    1. Barbara Roper

      Actually, Dodd-Frank included a provision removing all references to ratings in our federal financial laws and regulations. Regulators are currently in the process of implementing that requirement — trying to figure out what to put in their place. It’s a necessary step, but harder than it looks, since when you get rid of ratings you are left with little but the judgment of the financial institutions. Somehow, I find it difficult to trust the investment banks regarding the risks on their balance sheets. Rock, hard place.

      1. F. Beard

        Somehow, I find it difficult to trust the investment banks regarding the risks on their balance sheets. Rock, hard place. Barbara Roper

        The solution is any number of private ratings agencies whose survival would depend on their reputation, not government privilege.

  8. Mark

    Another appointed panel acting out? There are a large number of governmental agencies which are run by presidential appointees. These appointees must be approved of by congress. What happens when the Congress and the President are all on the same party line is that the vast bureaucratic ship of state turns towards a direction that looks a lot like a centralization of power and a primary dominion. These are things which the founders of America sought to avoid.

  9. Yancey Ward

    Since their role is embedded in the regulations, then shouldn’t government/s and their agencies also be sued?

  10. curlydan

    Call me a cynic. When they go after Moodys and Fitch with the same vigor, then I’ll try to change my perspective.

  11. dejavuagain

    Well, the rating agencies should be nailed to the wall.

    But, many of these securities ended up in the hands of pension funds, and all the funds had advisors, and many of the advisors receive kickbacks in the way of soft dollars if not direct kickbacks, and the SEC looks the other way at this if the adviser or seller of hedge fund is big. Some of these securities funneled through hedge funds and fund of funds with various “advisors” taking fees for doing absolutely nothing.

    So, who got stuck with the loss, exactly? And what happened to the advisers?

    Of, of course there is the issue of kickbacks to the trustees of these funds as well.

    The whole thing is a barrel of snakes and in the end, the pension funds took the loss, with no penalty to anyone involved.

    But, the SEC will not look at this mess, except on the periphery.

    But yes, nail the rating agencies, but also nail the advisers and trustees who put this junk into pension funds.

  12. Schofield

    It would benefit society that the law is clarified so that knowingly giving a false opinion, or rating, or failing to take due care in deriving them is punishable by jail time or heavy fines. The whole point of having markets (as opposed to Gosplan style state planning) is that they are more effective and beneficial by open and transparent information being available but attempting to manipulate the market by falsely assigning value undermines the working of those markets. It ought to be obvious to even the most dim-witted Neo-Liberal that having such improved regulation would be beneficial to the workings of the Invisible Hand although the cynic in me suggests that many Neo-Liberals are more interested in the Invisible Hand being that of a cat-burglar.

    1. F. Beard

      It would benefit society that the law is clarified so that knowingly giving a false opinion, or rating, or failing to take due care in deriving them is punishable by jail time or heavy fines. Schofield [bold added]

      A defense lawyer could drive a truck through those qualifiers.

      The absurd thing is this: Progressives allow an inherently dishonest and unstable activity – FR banking – and then wish to pile endless, highly subjective regulation on top of it in a ridiculous attempt to make it less dishonest and less unstable.

      Have they never heard of attempting to build on a foundation of sand?

      1. James Cole

        Most progressives haven’t an inkling of what “FR” might stand for (this progressive knows you are referring to fractional reserve) and in fact generally avoid economic thinking, which is pretty much the biggest problem with progressivism, aside from the fact that progressives of privilege don’t really want change that might impact their own privilege. But I digress. Interestingly, Adbusters, which is at the forefront of the OccupyWallSt protests, has been acting as a clearinghouse for fairly radical economic thought, including such notions as taking into account debits to the social balance sheet arising from extraction of natural resources and environmental and social externalities. They also publish clever “culture jamming” remixes of existing corporate ad campaigns.

  13. Schofield

    Irrespective of “driving a coach and horses through” terminology the point is that fraudently or negligently attempting to assign value outside of normal open and transparent market operations can only be stopped through legislation. The issue of abolishing the Federal Reserve in its current form is another matter of corruption to be dealt with in addition to that of the rating agencies.

  14. Glen

    I see the SEC as fundamentally broken, and don’t hold out much hope that this will be fixed anytime soon. The Obama administration still seems to be pushing essentially fake reform over any real change.

    Where ever we do see action, it seems to be almost to shield the failed banking system from any independent action by states, counties or individuals. Could this action be taken in any way to create a legal precedent which makes the rating agencies even more bullet proof from outside legal action?

    1. ug123

      In this day in age, shouldn’t investors stop relying on rating agencies (even though they exist)? Rating analysts move markets, but the markets should understand that the very people rating these obscure products are people like us who are capable of doing the research and due diligence ourselves. This leads me to my next question; why do they even exist when the most powerful hedge funds and money managers hire their own analysts (who are arguably better analysts than those of Moody’s and S&P)? We all understand that rating agencies hire humans who are capable of making mistakes, and we should all consider that before making investment decisions.

      1. steelhead23

        Yes, of course, every investor owes it to himself/herself and his/her clients to perform due diligence. But here’s a rub – if one makes an investment decision based on his/her own analysis, they are incurring a litigation risk (or at least I think they are). You see, even though we know the ratings agencies are conflicted if not corrupted, they have perceived validity. If you ran a bond fund, and bought AAA rated CDOs that turned into junk (actually, they always were junk, but I mean the ratings), you could claim you did your diligence and likely escape personal liability. However, if you made purchase decisions based on your own analysis and things went south – well, your investors may be able to extract plenty from you. And of course, many funds specify the ratings limits to their investment decisions, so they are slaves to the ratings – hence the conflicts.

        A better system would force originators to pony up the cost of a ratings analysis to a third party (SEC?) which would then purchase the services of a ratings agency(ies) for that specific issue. Over time, the third party could develop skill tests based on the performance of specific products over their lifetime and compare that to the ratings expectation and take steps to encourage the poorer performing agencies to improve (No Ratings Agency Left Behind).

        1. ug123

          The litigation risk may be a big problem; however, I believe that bond funds (specifically those that the every day investor places his/her money in) should be able to catch the red flag in their analysis, or at least be able to contest any results and not risk losing investors by overlooking the true fundamentals of products being offered; don’t you think? As an analyst, I would rather not invest in the product (and stay on the safer side) than invest with the thought that something can blow up anytime. In the end all these results are subjective and it will be tough if one party doesn’t have any power over the other. It might be easier for hedge funds to bypass this since LPs are considered “sophisticated investors.”

          I really like the idea of having a third party. This could even be applied to research analysts who are in conflict with the their Sell-side divisions. This will allow pure unbiased thinking to occur. Good point.

  15. Westcoastliberal

    Aren’t they a little late? About 3 years? Anyone who thinks these financial meltdowns just happen is totally wrong. Recessions, depressions and untold Human suffering through financial malfeasance has reached record heights and the rating companies are right there at the epicenter.
    Sure their ratings are “opinions”, but if the company behind the fund to be rated is paying for the rating, what do you think will happen? Same as with the blacklisted property appraisers who refused to “bring it in” where they wanted the price to drop.
    None of these Fed “consumer protection” or regulatory agencies really do anything but follow marching orders of their respective industries.

  16. ug123

    @Westcoastliberal: I totally agree with you, but as we evolve as a market, and more and more people realize that these agencies are error prone (and as we get more transparent of course), there will be a time when people will start ignoring these agencies and move on with their own independent beliefs; Don’t you think?

    Look what happened after the S&P downgrade. As the problems intensified in Europe, people completely ignored the fact that Treasuries were “riskier.” Yields dropped and continued dropping despite these negative ratings. In the end, rating agencies will be useless and should be put out of business. I believe that true market forces will eventually overpower these rating “Gurus.”

  17. Schofield

    Over the last thirty years Neo-Liberalism promoted the creed that instead of demanding “there ought to be a law against that” we should be demanding that “there ought to be a market for that.” The consequences are all to plain to see now after the Financial Crisis and the deep recession it gave us. A romantic belief that self-interest would always turn out to be for the common good was indeed a stretch to far and the pendulm is now swinging in the opposite direction in which we recognize the need to pragmatically guard against the ambivalence of human nature with strategems that offer the best chance of success.

    1. F. Beard

      A romantic belief that self-interest would always turn out to be for the common good was indeed a stretch to far and the pendulm is now swinging in the opposite direction in which we recognize the need to pragmatically guard against the ambivalence of human nature with strategems that offer the best chance of success. Schofield

      Human nature and greed is a given but what isn’t a given is government backing for banks. That in no way fits the definition of a “free market”. What you have discovered is that fascism does not work well even if practiced by Americans. Surprise, surprise!

  18. Economics Considered

    I mean no disrespect, since I have an enormous amount of respect and high appreciation for the truly robust number of issues detailed with such astute perspectives by Yves and guest posters.

    But — when are we going to not get pulled in one more time by another of these sham farces that are the ‘investigations’ and ‘suits’ against the financials ??????? Why on earth would be, even long ago much less at this late juncture, expect that the slightest meaningful result will come from one of these distraction and defuser smokescreens and cover perpetrated by the SEC et al ????? I am sorely puzzled at even a slightest minuscule expectation for something meaningful to happen.

    I apologize if what I regard as utter pragmatism about this sort of thing is felt to be cynicism instead. I would be pleased to be given substantial reasons to adjust my outlook.

    1. Foppe

      To be utterly pragmatic in turn: there is no organizational structure in place that allows people to organize along. (Note that I’m not saying that organization needs to happen via institutional lines, but that the existence of such latent structures are a precondition for effective organization, or simply to make it possible for people to reach each other. Whereas back in the ’30s you had the church, and the unions, which allowed people to communicate with each other, now the only sources of information/excitation they have are the newspapers/tv, and low-intensity voluntary associations.) The Tea-party could’ve sort of done that, but since it was co-opted, it won’t, and most other organizations are equally hopeless (or locally focused).. Until that changes (and this obviously won’t until people start organizing), little will happen that will be effective.

  19. Fiver

    Seconding the thrust of Economics Considered and others, it’s way past time to get serious about this. For starters, we need to call the Bush/Obama financial crisis what it is, i.e., an attack, a war, a coup, not a contrived legal, hostile takeover sanctioned by “we screwed you fair and square” Supreme Joke Law. It was Obama’s, or any President’s, clear duty in Jan 2009 to treat it as such, with the charges matching the crime – crimes of war/financial terrorism, which meant the FBI/DoJ taking some high-value prisoners at the outset, ending the ongoing bullshit right then and there, THEN methodically, with all due deliberations mopping up all the utterly rotten senior corporate officers in banks and other wayward financial corporations, the mortgage industry, law firms, judges, ratings agencies, some hedge funds and other “players”, regulatory agencies, etc., as well as a number of elected and unelected members of the Bush, and now Obama Admins and Congresses. If not jail, they’re all out of the Game permanently and all bogus earnings confiscated. Not one word of complaint, or it’s that AND jail.

    These people are not going to stop until stopped, and it’s not exactly clear how a path to any possible future Presidential/Congressional action along those lines is going to open up in this universe.

    We need another way. Some coherent way of organizing radical withdrawal of service or spending or cooperation or participation or anything other than expressing our core disgust with any of these people, a modern shunning, fer instance.

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