Here's yet another reason we may never trust credit-rating agencies again: One of the biggest of them has just suggested that we shouldn't.
The rating agency Standard & Poor's, and its parent company McGraw-Hill, on Monday responded in federal court to a $5 billion U.S. government civil fraud lawsuit by saying that S&P's own claims to have objective credit ratings, not corrupted by conflicts of interest, are what some federal judges have called "mere puffery" and not to be trusted.
Think about this amazing defense for a second, and try to imagine some real-world parallels. Imagine, for example, that I advertise my services as a house-sitter and call myself the most trustworthy house-sitter in town. Then I accidentally burn your house to the ground making s'mores with a bunch of hookers during a crystal-meth party that I throw while you're away. You sue me for the cost of your house, and I say, sorry, you shouldn't have trusted me when I said I was a trustworthy house-sitter. This is what is known as the Standard & Poor's Defense.
It is a fairly technical legal defense, a way to avoid federal fraud charges. The defense, and the word "puffery" itself, comes from a series of court rulings that have declared S&P's claims of objectivity and integrity so much boilerplate, rather than actionable fraud. Still, it comes at a decidedly awkward time, when public trust in rating agencies has fallen to its lowest ebb following the financial crisis, notes the Wall Street Journal's Jeannette Neumann, who first reported the S&P defense.
"Even if it's a viable legal argument, it's a pretty unattractive argument for S&P to be putting forward since they're basically in the business of charging clients for their reputation," Samuel Buell, a law professor at Duke University and a former federal prosecutor, told the WSJ.
The government claims that S&P defrauded investors by telling them that its ratings on collateralized debt obligations, which went to crap during the financial crisis, were based on stuff like research and objective analysis. The government claims that, instead of objectively analyzing the CDOs, S&P analysts were frantically trying to give these CDOs the best possible ratings, in order to win more CDO-rating business from the banks that pay their salaries and keep them in s'mores and hookers, all the while sending emails to each other about how crappy the CDOs were.
S&P says that we should ignore those emails, that they were just part of the company's "robust internal debate." It says its ratings were just dumb and unreliable, not fraudulent. But then it also says we should go ahead and ignore its claims of objectivity and integrity, while we're at it.
In that, S&P does have a point: You did have to be kind of an idiot to actually believe that its ratings meant anything. Everybody has long known, or should have known, that the rating agencies were conflicted. The conflict is built right into their business model, because they are paid by the banks that produce the bonds that they rate. And that applied to all of the big agencies, not just to S&P, which is why S&P is understandably confused as to why the government is suing it alone.
This conflict was a problem before the crisis, and it remains a problem now. And though regulators have made loud noises about doing something about this problem, they have not done much in the way of solving it.
Which means that we could once again be in a situation in which a rating agency's ratings turn out to be woefully wrong. By that point, nobody will have any excuse for being surprised. S&P has all but told us to expect it.