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Revenge or righteous reaction?

Publication Date : 08-02-2013

 

Credit rating agency Standard & Poor's is under fire. The US Justice Department on Monday launched a lawsuit against S&P's for alleged misdeeds that led to the 2008 financial crisis. It is rather bizarre that the Justice Department has left out Moody's Investors' Service and Fitch Ratings, the other two main ratings agencies.

S&P's provides bond ratings or assesses the creditworthiness of issuers and the value of their collateral. It offers the ratings service for a fee. Investors need S&P's ratings service through its credit rating system because they do not have the knowledge or the expertise to evaluate the creditworthiness of issuers.

As it turned out, the 2008 financial crisis caught most people off guard.

The low interest rate environment during US Federal Reserve chairman Alan Greenspan's era fuelled the housing and financial bubbles. Banks and housing bank agencies extended cheap loans to customers, who might otherwise have not been able to afford houses in the first place. But they were all led to believe that the housing market was invincible.

The only way for housing prices to go was up - indefinitely. If homebuyers could not pay the instalments, they could still get out unscathed because of rising property prices. Banks could foreclose the homes to recover the loans for a profit. Everybody was in the game. That was why there were so many sub-prime homeowners.

Investment banks joined the bandwagon by bundling housing loans as mortgage-backed securities for further trading in the secondary market. They also devised structured asset-backed securities with multiple tranches collateralised by debt obligations including bonds and loans. These were exotic financial instruments.

S&P's is now in hot water because it provided top ratings for exotic financial instruments called collaterised debt obligations (CDOs). Most investors had no idea what CDOs really were. Still, they bought into them because the investment bankers were applying a hard sell. The investors also felt confident in the creditworthiness of the CDOs by looking at the ratings from the rating agencies.

But all bubbles burst. When the housing market crashed and the bubbles burst in 2008, investors in the CDOs and other financial instruments lost their shirts. A Thai bank, which snapped up CDOs, lost several billion baht in its investment portfolio. Investors were angry that the rating agencies misled them about the creditworthiness of these exotic financial instruments. Top ratings turned into massive defaults.

The collapse of the sub-prime housing market was dramatic, almost bringing down the global financial system. The size of the US housing market was about US$12 trillion. This led to a run on investment banks. Wall Street firms such as Lehman Brothers, Bear Stearns and a host of others folded or were subsequently taken over by larger institutions. The federal government and the Federal Reserve stepped in with a bailout. A massive liquidity input of $16 trillion was printed by the Fed to prop up the global banks between 2008 and 2010. Without Fed money, the global banking system would already have been wiped out.

It should be noted that in 2011 S&P's downgraded the US government's credit rating. It was no secret that the Obama administration was really offended by the downgrade, coming at a time when it was battling against the Congress over the debt ceiling. Now the US Justice Department is taking on S&P's for its alleged inflated ratings and mortgage investments prior to 2008. This has raised eyebrows and suspicion that the US government is taking revenge against the agency.

Floyd Abrams, the lead attorney for Standard & Poor's, told CNBC on Tuesday that "the intensity of the investigation" into the agency's bond ratings "significantly increased" after S&P's downgraded the US government's credit rating in 2011. Moody's and Fitch have been spared the wrath.

S&P's plans to downgrade the US government debt further if Congress and the White House, between March and May this year, fail to agree on a credible plan to bring the deficit down. A downgrade would punish the dollar badly and shatter the dollar's role as the world's reserve currency.

Could this lawsuit succeed in neutralising S&P's? And if so, in the future would any rating agency dare to incur the wrath of the US government?

 

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