Bond Raters Become Government Hostages

When I see a hostage on television, pleading with his government or his family to meet his captors’ demands, I sympathize with the victim but pay no attention to the message. Views expressed under duress have no credibility.

Which is why, as far as I am concerned, the U.S. Treasury has surrendered the AA+ rating it held from Standard & Poor’s and the sterling triple-As it held from S&P’s credit-rating competitors. Now that the government has unleashed a legal hit squad against S&P – and, in the process, delivered a none-too-subtle warning to the other rating agencies – the agencies no longer have the independence or legal maneuvering room to tell us what they really think about our nation’s finances, even if they want to do so.

S&P, the largest credit agency as well as the first to declare that Treasury obligations were not riskless, now finds itself the target of a civil fraud lawsuit that the Justice Department filed in Los Angeles this week. More than a dozen state prosecutors are expected to hop on Justice’s legal bandwagon, and the Securities and Exchange Commission may follow close behind.

Despite substantial precedent indicating that credit ratings are opinions protected by the First Amendment (and one contrary decision, by U.S. District Judge Shira Scheindlin of Brooklyn, defining them as something between opinion and fact), the Justice Department decided to make an example of S&P. The suit nominally has nothing to do with the agency’s Treasury debt rating; it deals instead with ratings for bonds that were created from mortgages and other obligations that were packaged and sold to investors. You and I are supposed to accept that it is pure coincidence that S&P, which complicated President Obama’s re-election campaign by downgrading its view on U.S. credit, is the sole target of this lawsuit, even though all the ratings agencies behaved similarly in the years leading up to the financial crisis.

S&P and its peers surely made mistakes amid last decade’s credit bubble. So did thousands of other players, including the Federal Reserve and the then government-sponsored, now government-controlled finance agencies Fannie Mae and Freddie Mac. But only S&P is the target of a potentially ruinous civil case blaming it, and it alone, for some losses that the government incurred when the housing bubble burst.

S&P’s biggest mistake may have come more recently: It tried to negotiate with prosecutors who are seeking scapegoats rather than justice. Before the lawsuit was filed, S&P reportedly offered to settle the government’s $5 billion claim for a payment of $100 million, without an admission of any fraud. But the government apparently demanded at least $1 billion in cash and the admission of fraud, which could have cost S&P far more in the long run, possibly putting the agency out of business entirely.

While a $100-million penalty might have seemed an acceptable price to make the problem go away, this sort of appeasement, practiced throughout the business community, has only encouraged the government’s repeated overreaching. Prosecutors literally have nothing to lose. Even if the lawsuit falls apart, Attorney General Eric Holder is not personally on the hook for anything. As a public official acting in the capacity of his office, he has immunity in every court except the court of public opinion, where the only penalty is contempt.

If I were on the board of an entity that invests in only AAA-rated securities, I would no longer consider U.S. government obligations to qualify. As a practical matter, no U.S.-based ratings agency is any longer in a position to objectively issue or change such a rating.

As I wrote previously, the ratings agencies should all withdraw their ratings on government debt – the federal government’s debt immediately, and the debt of any state that joins this suit when it does so. The ratings agencies should also band together to fight for the principle that ratings are opinions, not guarantees. That principle is crucial to their ability to function. Even a triple-A security is not risk-free. There is still some small risk of known contingencies occurring, and there is always the additional risk of some unforeseen situation (such as the sharp and widespread decline in housing prices, an occurrence that was not contemplated during the recent boom) exposing risks that were not previously recognized.

The Justice Department is making every effort to reduce its case against S&P to a kangaroo proceeding. It carefully chose the venue in Southern California, an area hit hard by the housing crisis, where jury pools will include a lot of people who suffered foreclosures. It brought civil, not criminal, fraud charges, and it brought those charges under a 1989 law that demands the lowest standard of proof available in federal courts – a mere “preponderance of the evidence.” Not only is this standard far lower than that of “beyond a reasonable doubt,” which is used in criminal cases, it is also much weaker than the “clear and convincing evidence” required in other civil actions. The statute in question was passed during another anti-banker backlash, amid the savings and loan crisis in 1989.

This isn’t law enforcement or regulatory oversight. It’s a lynch mob in suits.

S&P, the first rating agency that dared call the U.S. government a less-than-pristine credit risk, is now the U.S. government’s hostage. I have faith in the courts to eventually put things right, but I am afraid it is going to be a long time before the hostage is released.

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