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Standard & Poor's

Standard & Poor’s is best known for stock market indices such as the US-based S&P 500 and for its credit ratings, competing against Moody's Investors Service and Fitch Ratings. Rating agencies came under fire for issuing top ratings to pools of mortgages which included subprime loans and in February 2013, the US Justice Department filed a civil lawsuit against S&P, seeking US$5 billion in civil damages.

BusinessBanking & Finance

Standard & Poor's looks secure despite US government lawsuit

Standard & Poor's, accused of helping to plunge the world into recession, is being taken to court - but its privileged position seems secure

PUBLISHED : Thursday, 07 February, 2013, 12:00am
UPDATED : Thursday, 07 February, 2013, 5:16am

The lawsuit against Standard & Poor's by the US government raises pressure to accelerate competition in the ratings industry, while the government itself has adopted rules that left the business dominated by the same companies whose flawed grades helped spark the worst financial crisis since the Depression.

The Department of Justice accuses McGraw-Hill and its subsidiary Standard & Poor's of deliberately understating the risk of bonds backed by mortgages made to the riskiest borrowers, in order to win business from Wall Street banks.

S&P, Moody's Investors Service and Fitch Ratings provided 96 per cent of all ratings for governments and companies in the US$42 trillion debt market in 2011, down only slightly from 97 per cent in 2008.

The lawsuit is unlikely to alter that, because a law passed in 2006 that was intended to open the field to new entrants has instead insulated the top three. Startups have struggled to obtain the designation that lets them sell rankings because of everything from a missing recommendation letter to prohibitive compliance costs to being able to provide years of ratings performance. Even as the biggest investors say they disregard the grades, their use is still embedded in bond deals and bank reserve rules.

The law "discourages entry and discourages new ideas and new ways of doing things," said Lawrence White, a professor of economics at New York University's Leonard Stern School of Business. "Ironically, it reinforces the position of the big three."

Judith Burns, a spokeswoman in Washington for the Securities and Exchange Commission, which oversees applications for ratings firms, declined to comment on the process.

In 1936, during the Depression, banks were banned from holding bonds that were below investment grade, or securities rated under BBB-minus by S&P and Baa3 at Moody's. In 1975, SEC regulations designated S&P, Moody's and Fitch as "nationally recognised statistical rating organisations", or NRSROs, and required some investors to buy only securities stamped with the companies' creditworthiness opinions.

Under rules outlined in the 2006 Credit Agency Reform Act, there are now 10 NRSROs.

These changes have helped the seven smaller firms gain market share from the big three in some asset classes. Kroll Bond Rating Agency issued grades on US$21.2 billion of commercial mortgage-backed securities last year, the third most behind Moody's and Fitch, according to Commercial Mortgage Alert, an industry publication. The Toronto-based DBRS has seen its CMBS rating market share more than double to US$16.5 billion.

Lawmakers targeted the credit-grading business in the 2010 Dodd-Frank Act after the collapse of top-ranked mortgage-backed securities contributed to US$2.1 trillion in losses at the world's largest banks. Reports from the US Senate and the Financial Crisis Inquiry Commission blamed failures by the companies as a cause of the financial crisis, which began in 2007.

According to the justice department complaint, filed on Monday, S&P falsely represented to investors that its ratings were objective, independent and uninfluenced by any conflicts of interest. The company shaped its analysis to suit its business needs to the extent that one analyst of collateralised debt obligations said loosening the measure of default risk for one security in 2006 "resulted in a loophole in S&P's rating model big enough to drive a Mack truck through," the justice department said.

McGraw-Hill shares fell the most in 25 years after S&P said it expected the lawsuit. Moody's share price dropped the most since August 2011. McGraw-Hill and Moody's, both of New York, each had been trading at five-year highs. McGraw-Hill, which ended last week at US$58.34, fell 10.7 per cent on Tuesday to US$44.92. Moody's dropped 17 per cent in two days to US$45.09.

A "competitive moat" around the top three firms has resulted in virtually no change in their market share in the past six years, Peter Appert, an analyst at Piper Jaffray in San Francisco, wrote in a report last month. Investors should buy stock in McGraw-Hill, he said on Tuesday, because "litigation risk has proven manageable."

That moat has barely been breached by new SEC rules. Ann Rutledge, a structured finance specialist, said she had watched her application to become an NRSRO languish at the SEC for 20 months. Her company, R&R Consulting, has yet to be granted a licence because some of the eight client letters do not meet the requirements of a credit rating as defined by the law passed in 2006. The statute specifies that only written testimonials that are notarised from institutional buyers attesting to its ratings may be used. R&R's clients include pension funds, hedge funds and governments.

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