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Is S&P's $1.38B deal enough to keep credit raters in check?

| Wednesday, Feb. 4, 2015, 12:01 a.m.
FILE - This Oct. 9, 2011, file photo shows 55 Water Street, home of Standard & Poor's, in New York. S&P is paying approximately $1.38 billion to settle government allegations that it knowingly inflated its ratings of risky mortgage investments which helped trigger the financial crisis.
FILE - This Oct. 9, 2011, file photo shows 55 Water Street, home of Standard & Poor's, in New York. S&P is paying approximately $1.38 billion to settle government allegations that it knowingly inflated its ratings of risky mortgage investments which helped trigger the financial crisis.

WASHINGTON — More than six years after the financial crisis struck, credit rating giant Standard & Poor's will pay a hefty $1.38 billion penalty for its role in fueling the subprime mortgage meltdown. But that doesn't mean it can't happen again.

The Justice Department announced S&P's settlement Tuesday with the federal government, 19 states and the District of Columbia over ratings issued from 2004 through 2007 by the McGraw Hill Financial subsidiary. Pennsylvania will receive $21.5 million in the settlement, the bulk of which will be given to state agencies that bought securities using the credit rating giant's guidance, Attorney General Kathleen Kane said.

S&P's ratings were used by investment managers hired by the state agencies to make investment decisions, including in residential mortgage-backed securities and collateralized debt obligations that fed the housing bubble, Kane spokesman Aaron Sadler said. He did not know exactly how much the state lost on its investments but said it was “in the millions.”

Out of Pennsylvania's share of the settlement, $15 million will be split among the Treasury, Public School Employees Retirement System, State Employees' Retirement System, Pennsylvania Municipal Retirement System and the Turnpike Commission. The Attorney General's Office will take $5 million for litigation costs. Treasury, the three retirement systems, Department of Insurance and the governor's office will receive $250,000 each to cover litigation costs.

S&P's settlement marks a public chastening of a major credit rating agency accused of knowingly overrating toxic mortgages that ignited the crisis. S&P and its competitors are crucial gatekeepers that can affect a company's or government's ability to raise or borrow money. In the aftermath of the crisis, federal regulators have imposed changes on how the rating agencies conduct business.

Yet the fundamental conflict of interest at the heart of the rating agencies' business remains intact: They continue to be paid by the companies whose securities they rate.

“This doesn't fix anything,” said Janet Tavakoli, the president of Tavakoli Structured Finance and a former investment banker. “This is just a traffic ticket.”

Tavakoli cites a number of problems, including payments that companies and banks make to the agencies for ratings, as well as flawed statistical methods. The government should go further and strip the big rating agencies' national licensing for rating complex securities, she suggested.

The process for companies and rating agencies is akin to having a pitcher choose the umpire, critics of the industry say, and it puts pressure on the agencies to award better ratings in order to secure repeat business.

That's exactly what the government asserts S&P did in ratings on billions of dollars of securities that it issued from 2004 through 2007. The settlement resolves a court fight that began with a Justice Department lawsuit two years ago. S&P was accused of failing to warn investors that the housing market was starting to collapse in 2006 because doing so would hurt its ratings business.

Under the agreement, S&P acknowledged that it issued and confirmed positive ratings despite knowing that those assessments were unjustified and in many cases based on packages of mortgages that it knew were likely to default.

“On more than one occasion, the company's leadership ignored senior analysts who warned that the company had given top ratings to financial products that were failing to perform as advertised,” Attorney General Eric Holder said.

S&P agreed to retract its earlier allegation that the government had brought the action in retaliation for its downgrade of the United States' credit rating in 2011, a concession that Holder said is personally important to him.

The three big rating agencies — S&P, Moody's Investors Service and Fitch Ratings — have been blamed for helping fuel the 2008 crisis by giving strong ratings to high-risk mortgage securities. The ratings made it possible for banks to sell trillions of dollars' worth of those securities. Some investors, such as pension funds, can only buy securities that carry high credit ratings.

Under a 2010 mandate from Congress, the Securities and Exchange Commission has enacted a series of rules for the rating agencies.

The new regulations require the agencies to provide more details about how they determine each rating. To address the perceived conflict of interest for rating agencies, the rules bar the agencies' sales teams from participating in the ratings process.

Agencies must also review and potentially revise their ratings in cases where an employee was later hired by a company he or she evaluated.

The agencies must file a report each year showing how they monitor ratings, how each rating changed over time and whether the securities or companies later defaulted.

Critics say a better solution would be to create a government board that randomly assigns agencies to rate companies. Congress debated that idea when it put together the financial overhaul law in response to the 2008 crisis. But lawmakers pushing the idea were unable to include it into the legislation.

S&P “got off pretty light considering they helped bring down the world's financial system,” said James Cox, a Duke University law professor and securities market expert.

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