Standard & Poors and Moodys -- Government Agencies

What happens when agencies with the government seal of approval then extend their good name to give high ratings to securities of dubious value? Here's what happens. The analysts at S&P and Moodys who helped Wall Street firms by giving high rating to complex securities are rewarded with lucrative jobs at those Wall Street firms. Just like high ranking military officers who become lobbyists for defense contractors.

There are ten firms that are known as Nationally Recognized Statistical Ratings Organizations. Moodys and S&P are two, the best known two. Thus, when it comes to opinions on all the securities these firms evaluate, the government has stood behind them and their word. Big mistake. The government should treat this issue the same way it treats religion. There should be a separation between the Church of Wall Street and Government. Instead, the government has put a premium on the work of the 10 ratings firms. Thus, their words was not doubted and challenged when it should have been. Big mistake.

Raters Draw SEC Scrutiny

U.S. securities regulators are weighing civil fraud charges against some credit-rating companies for their role in developing the mortgage-bond deals that helped unleash the financial crisis, according to people familiar with the matter.

The Securities and Exchange Commission's long-running probe into the deals has widened to the major credit-rating firms, including Standard & Poor's, the people said.

The leading ratings companies have been criticized by lawmakers as "key enablers" of the financial meltdown, helping to fuel the $1 trillion Wall Street mortgage-securities machine before the boom ended.

But the major ratings firms have largely avoided any regulatory crackdown and beaten back private lawsuits. Their business has rebounded as financial markets regained their footing.

Now, SEC officials are focusing on the question of whether the ratings companies committed fraud by failing to do enough research to be able to rate adequately the pools of subprime mortgages and other loans that underpinned the mortgage-bond deals, according to people familiar with the matter.

It is a common tactic for regulators to accuse financial firms of fraud for allegedly misrepresenting information to investors, either recklessly or intentionally, according to lawyers. In the case of the rating companies, the firms could face allegations from the SEC that they relied on incomplete or out-of-date information supplied to them on the pools of loans in the mortgage-bond deals or ignored clear signs of problems among subprime loans and so gave unduly high ratings to slices of the deals that were then sold to investors, say people familiar with the matter.

The SEC is looking closely at the conduct of Standard & Poor's, a unit of McGraw-Hill Cos., said people familiar with the matter. They said the agency is also reviewing the role played by Moody's Investors Service, owned by Moody's Corp., in relation to at least two mortgage-bond deals.

The inquiry may not lead to charges against any of the credit-rating firms.

A Standard & Poor's spokeswoman declined to comment. Michael Adler, a spokesman for Moody's, said: "Although Moody's is uncertain as to what The Wall Street Journal is referring, we would certainly cooperate with any requests we receive from the SEC."

The inquiry into the rating companies marks a broadening of the SEC's long-running investigation into the sales and marketing of the mortgage-bond deals by several major Wall Street's banks. Goldman Sachs Group Inc. was sued by the SEC last year in the first big case to come out of the inquiry. Goldman paid $550 million to settle the charges. The firm admitted making mistakes but didn't admit or deny wrongdoing.

A new wave of cases involving fraud allegations against banks and other financial firms related to the deals is expected shortly, say people familiar with the matter. They said the agency is aiming for a second wave of settlements in the fall, with a third and final group possible by the end of the year.

J.P. Morgan Chase & Co. is among the first banks in line for a settlement of charges expected by the SEC, people familiar with the matter said. The New York investment bank is expected within weeks to settle these allegations related to its sale of a $1.1 billion mortgage-bond investment, called Squared, as the housing market was collapsing in early 2007. J.P. Morgan and most of the other banks that are expected to face allegations of fraud in relation to mortgage-bond deals are expected to agree to pay about half or less than the $550 million Goldman paid to settle the SEC charges, according to people familiar with the matter.

J.P. Morgan and the SEC declined to comment.

Other financial firms in the SEC probe include Citigroup Inc., Morgan Stanley, Bank of America Corp.'s Merrill unit and UBS AG, according to people familiar with the matter. The companies declined to comment.

The widening of the SEC inquiry to credit-rating companies puts them back in the regulatory and legal spotlight. The firms played a crucial part in the creation of the mortgage-bond deals, known as collateralized debt obligations. CDOs are based on complex pools of mortgages and other loans, made up in part of risky subprime mortgages. The pools were sold in slices to investors.

The ratings firms assigned coveted triple-A ratings to many of these CDO slices in the run-up to the crisis, before doing mass downgrades when the housing market collapsed and the subprime mortgages soured.

To be sure, the credit-rating companies aren't responsible for the accuracy of the data supplied to them to rate securities. But they could be accused of ignoring obvious flaws in the data, such as it failing to reflect the deterioration of the mortgage market, according to lawyers.

The ratings companies also enjoy significant legal protections, which they have used to fend off some lawsuits. In May, the credit-rating firms notched a legal victory when a U.S. Court of Appeals ruled that they can't be held liable for their ratings of mortgage-backed securities. Their ratings, the judges wrote, were "merely opinions" and protected by the First Amendment, a defense the firms have often used in the past.

A rare example of a regulatory case against the companies is the lawsuits filed last year by Richard Blumenthal, the then-Connecticut attorney-general, against Standard & Poor's and Moody's. The suits, alleging the firms knowingly assigned tainted credit ratings to mortgage-bond deals, are being contested by both firms.

Moody's and Standard & Poor's have mostly avoided costly legal settlements since the financial crisis.

The credit-rating companies have also benefited from a law that was expected to improve their performance. The Credit Rating Agency Reform Act of 2006 bars the SEC from regulating the substance, criteria or methodologies used in the credit-rating models. The current investigation avoids these areas.

Security Analysis -- Credit Rating -- AAA or Junk?

There are no mysteries about assessing the quality of a bond or other fixed-income security. Credit analysts have been at it for a long time. But if we know what we are doing, why do we sometimes get it wrong, horribly wrong? In a nutshell, through good intentions, the government made a mess of things.

Put the Rating Agencies Out of Their Misery Before It's Too Late

A pillar of the financial crisis was rating agencies slapping triple-A ratings on junk mortgage products only to be mystified when the securities blew up. In the 2007 transaction involving the recent Goldman Sachs (NYSE: GS) CDO fraud saga, almost half of the debt was downgraded from triple-A (perfect) to junk (perfectly worthless) in short order.

Fool me once ...

Now, a sober person would think the rating agencies have learned from these flubs. But that makes too much sense. Truth is, they're as miserably inept as ever.

Last summer, Standard & Poor's invoked the ghost of 2005 when it rated a set of CDO-esque securities triple-A, which implies essentially zero probability of default.

Last week, it downgraded the same securities all the way to junk. That's triple-A to junk in less than a year. Again. Recall Einstein's definition of insanity, and feel free to smash your head against the nearest wall.

"The downgrades reflect our assessment of the significant deterioration in performance of the loans backing the underlying certificates," cried S&P. This is mildly true at best, and more likely a product of the same deceptive shell games rating agencies are now infamous for.

Here's your pig, there's your lipstick. Have at it.

These securities, you see, weren't new products created last summer when S&P initiated the ratings. They're called "re-remics," born from an alchemical process of taking existing bonds struggling for survival, slicing them up anew, and giving the new pieces a fresh set of ratings. The idea is that you can take a low-rated mangled mortgage bond, extract the pieces that still have a heartbeat (even though they share the same characteristics as the rapidly defaulting mortgages), and pronounce the new security triple-A.

So to be sure here, the same material that S&P called triple-A last summer was, at nearly the same time, rated far below that. David Blaine can't even fathom this stuff.

During a flood of re-remics last fall, The Wall Street Journal wrote an article questioning their validity "partly because re-remics rely on ratings firms -- faulted for failing early on to identify problems with mortgage-backed bonds -- to rate the new securities." That was spot-on, as was a comment by Rep. Dennis Kucinich, who warned, "The credit-rating agencies could be setting us up for problems all over again."

That's exactly what's happening, and it's time we do something about it. One of the central flaws in the rating agency world is that large-scale investors such as money market funds are required to hold assets scored by a rating agency registered as a Nationally Recognized Statistical Rating Organization, or NRSRO. Only a handful of raters are blessed with this status, and Moody's (NYSE: MCO), S&P, and Fitch are kings of the court. They're privileged to what amounts to guaranteed business and no threat of new competition.

While it's certainly well-intentioned, there's fairly universal agreement that the NRSRO has created the ability, if not the incentive, for rating agencies to produce wildly flawed work. They have nothing to lose. Investors have to use their services. S&P can recklessly issue wacky ratings (as it just did), and business goes on as usual.

Hedge fund manager David Einhorn summed it up perfectly: "Nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government-created oligopoly and often because they are required to by law." In any normal market, new competition and customers' disgust over shoddy analysis wouldn't let this happen.

Let's do something about this

Fortunately (though long overdue) Congress is waking up. Two amendments in the just-passed Senate financial overhaul bill could euthanize the flawed parts of the rating system.

One amendment would eliminate all mention of the NRSRO from federal regulations. The organization could still exist, but language requiring investors to use products rated by an NRSRO rating agency would vanish. Competition from eager rivals like Morningstar (Nasdaq: MORN) and KPMG could then step in and sanitize the industry.

A separate amendment would create a clearinghouse set up to assign rating agencies with deals. That way, banks that issue credit products couldn't shop around for the morally bankrupt rater that's willing to assign triple-A status to toilet paper just to bag a nice fee. Both amendments aim to end a kink in the financial system that benefits exactly nobody except the rating agencies and the banks that sell glorified debt products.

We'll be patiently watching as the Senate and House reconcile their respective versions of the financial overhaul bill. Stay tuned.