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.”