S&P Ratings Gets a Tap on the Wrist

Let’s just say I’m not surprised by the Justice Departments $1.4 billion fine, or what I’ll call a “tap on the wrist” to Standard & Poor’s. Levied as a result of years of bandying back and forth, the fine is S&P’s punishment for giving overwhelming endorsements—AAA ratings (the highest)—to thousands of subprime loan packages from 2007-2009.

You know how the story ended. Eventually, the loans that “should have never been made” went belly-up when homeowners could not make their payments, and some 4.4 million homes were foreclosed, sticking investors with rotten assets and helping to cause the decimation of the real estate market.

There were lots of reasons behind the bubble, including inflated housing prices, a go-go economy, and low interest rates. But the primary catalyst was unadulterated greed—by homeowners, mortgage lenders, and the rating agencies that took money from the very folks they were rating! Consequently, why was anyone surprised that the “paid for” ratings were stellar?

And now, of course, we have the small fine. I say small, because trillions of dollars were lost during the financial crisis. There have only been a few miniscule fines levied, no one has gone to jail for their part in the debacle, and while there have been changes in the ratings agencies methodologies since the crisis, the fact remains—they are still paid by the folks they rate.

This just doesn’t make sense to me. It’s similar to the brokerage firms’ research departments giving inflated ratings to the stocks they are being paid to underwrite. Or the PR machine newsletters that hype stocks because they are paid to do so—and are not independently analyzing them, as they often claim to unwitting investors.

Millions of investors depend on the ratings from these agencies to buy bonds that are issued by municipalities, state and federal governments, and corporations, all of whom need their funds to expand their businesses. So why shouldn’t investors expect unbiased ratings?

I talked with Martin Weiss about this subject. Several of Martin’s editors with Weiss Research are contributors to our Dividend Digest and Investment Digest. While Martin has been a nationally-recognized economics expert for decades, he’s also known as a pretty feisty consumer advocate. He created an independent ratings system many years ago in response to this very issue—biased ratings. His system is a comprehensive research vehicle that accepts no money from the companies he rates. And I may also say that he has an excellent track record, and was one of the first economists to sound the alarm about the subprime crisis—long before the rest of Wall Street.

With that in mind, I asked Martin what he thought of the S&P fine. Here’s what he had to say:

“S&P is not alone. The business model of all major ratings agencies—including Moody’s, Fitch Group and A.M. Best Company—is predicated on serious conflicts of interest akin to payola. Simply stated, the ratings they issue are bought and paid for by the same companies they rate.

“What’s worse, by granting the rating agencies the privileged status of Nationally Recognized Statistical Rating Organization (NRSRO), the U.S. Congress and regulatory authorities effectively bless their practices. It is one of the greatest and least understood scandals of our time, and no amount of fines will protect the countless numbers of individual investors who fall victim each and every day.

“A more reasonable solution: To qualify as an NRSRO, each agency should be required to demonstrate it is completely free of conflicts of interest. Alternatively, if it chooses to continue its current practices, it should lose the coveted NRSRO status and be required to clearly disclose to the public its practices and their inherent risks.”

I have to say I agree. If you do too, let your legislators know. I believe wholeheartedly in our system of investing—that with enough research, investors can build a winning portfolio. But if some of the information we rely on is not unbiased, we may hold a losing hand.

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