Monday, September 26, 2011

The Witch Hunt for S&P

It's hardly news to anyone these days that S&P erred, substantially perhaps, in their rating of sub-prime mortgage bonds, CMOs and related products. Tranches rated AAA ultimately resulted in downgrades to sub-investment grade and even default.  In the aftermath of the credit crisis, investors lost substantial value on these downgrades.

All this, now common knowledge in retrospect, was far less evident to the folks at S&P at the time the ratings were instituted.  This point is corroborated by the fact that largely identical ratings were assigned by Moody's and Fitch on the very same securities now in question.  Mistakes were clearly made and this is why to great degree all rating agencies refer to their ratings as rating "opinions".  Ratings are not designed to be a definitive, official views or to be guarantees or insurance policies.

Be that as it may, as a matter of practice, financial professionals and investors alike had grown accustomed to relying on ratings as a basis of their investment decision, with the markets setting trading levels based upon credit spreads, or the degree to which the given rating departed from the US "AAA".  Whether such reliance is appropriate or prudent, however, is a question that the SEC has chosen to dismiss in its issuance of a Wells Notice to S&P.

With the SEC plan to investigate the rating practices of S&P, the SEC will be arguing that S&P willfully or negligently mislead the market with their ratings on CDOs. This raises several questions, none of which are particularly sensible. Moreover, following the highly publicized downgrade of US Government debt by S&P, and the obvious political embarrassment to the Obama administration, the action also raises a far more troubling question about the depth and breadth of Federal agencies in prosecuting for political, rather than public good.

First, we have to ask, "Why S&P"?  The vast majority of sub-prime mortgage bonds, CDOs and related securities carried in each case more than one rating.  It has long become accepted practice of the bond market to require a minimum of two ratings on each new issue.  So if Moody's and S&P both rated the very same issue "AAA" how is it reasonable that the SEC only finds alleged fraud in the rating of S&P?

Second, if the ratings are credit opinions, and irrespective of whether you accept the rating agencies claim of protection under the first amendment, how is it that the SEC can allege fraud?  No one was forced or coerced to accept or rely under their opinion and, in fact, prudent investors conducted their own in-house, independent credit analysis of the securities.

This now raises the far more dark and terrifying question of whether our government  is capable of the sort of witch hunts, slander and politically motivated prosecutions of a truly oppressive, totalitarian regime.  Despite the best attempts of our current congress to degrade public sentiment toward our government, few Americans truly believe this to be possible.  This is America and we are a democracy, ruled by officials chosen in fair and open elections. 

But to argue that today's SEC action against S&P is purely coincidental and not retaliatory is simply far too unreasonable for us to believe.  The SEC, clearly asleep at the switch throughout the extended market events leading up to the credit crisis, has now further tarnished its reputation by playing the role of bad cop for the Obama administration.