What Exactly Does S&P stand for?

I don’t often put on the finance hat part of the financial economist moniker ’round these parts, but I couldn’t resist donning it long enough to pooh pooh S&P.  It’s hard to take the bond rating portion of their business seriously when they do things like this:  “Subprime Mortgage Bonds Getting AAA Rating S&P Denies to U.S. Treasuries”.  How much sense does that make?

Standard & Poor’s is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government.

S&P is poised to provide AAA grades to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties. New York-based S&P stripped the U.S. of its top rank on Aug. 5, saying Washington politics were making the country less creditworthy.

Treasuries gained about 1.95 percent and U.S. borrowing costs have fallen to record lows as investors repudiated the downgrade, according to Bank of America Merrill Lynch indexes. S&P has awarded AAAs to more than $36 billion of securities in the U.S. this year that were created by bankers who continue to gather thousands of loans, bundle them into bonds of varying risk and pay ratings firms a fee to assign credit rankings.

“Everybody has been led to believe over the years that AAA means AAA means AAA across the board,” Gregory W. Smith, the general counsel for the $41 billion Public Employees’ Retirement Association of Colorado, said in a telephone interview on Aug. 24. “Anybody that didn’t learn in the 2008 crisis that doesn’t apply should find another line of work.”

Yup, that’s right.  The same bonds in a still stinky market are getting better ratings than assets that are basically still serving as a universal safe haven and are showing signs of being about the only bull market among the surly August bears.  Lest we forget, even a Senate subcommittee found that S&P’s inflated ratings significantly contributed to the financial crisis of 2007-2008. It’s somewhat obvious the market doesn’t believe the raters given the current pricing of US Treasuries.  However, these kinds of ratings still remain important in some circles around Wall Street despite what seems like monumental problems and conflicts of interest.  It’s difficult to imagine a for profit business not being influenced by large, paying customers.  The reason they remain key is that many charters of institutional investment funds have minimum ratings requirements and institutional funds are a huge chunk of the market.

Even after Congress included rules in the Dodd-Frank Act last year designed to cut reliance on ratings, S&P and its competitors remain a key part of the financial markets. Pension and mutual funds often require minimum ratings to buy debt securities. Banks are generally required to hold less capital to back higher rated bonds as regulators including the Federal Reserve have yet to find an alternative.

The Justice Department is probing S&P and Moody’s over mortgage-bond ratings between 2005 and 2008, according to three former analysts who said they were interviewed by investigators. The Senate Banking Committee and the Securities and Exchange Commission are scrutinizing the decision to downgrade the U.S. rating, according to people with knowledge of the inquiries.

The Justice Department probe is fairly new, but details show that the probe is based on these potential conflicts of interest.  Still, there are hints that the probe was also a possible political strategy to press the rater to raise the rating on U.S. sovereign debt.   The Justice Department does have to prove a case before a judge so that could offset any political motivation in the long run.

The Justice Department has been asking about instances in which S&P analysts wanted to assign lower ratings to mortgage bonds but may have been overruled by S&P business managers, the newspaper reported. Its story cited unidentified sources familiar with the matter.

It was unclear whether the Justice Department investigation involves the other two ratings agencies. A Justice Department spokesman was not immediately available for comment.

Ed Sweeney, a spokesman for S&P, told the newspaper in an e-mail that the agency had received several requests from different government agencies over the last few years and that it was cooperating.

The newspaper said that despite the outcry over the ratings agencies’ failures in the financial crisis, investors still rely heavily on ratings from the three main agencies for their purchases of sovereign and corporate debt, as well as other complex financial products.

Companies and some countries, though not the United States, pay the agencies to receive a rating. For decades, the government issued rules that banks, mutual funds and others could rely on a AAA stamp of approval for investing decisions — which bolstered the agencies’ power, the newspaper said.

A successful case or settlement against a giant like S&P could accelerate the shift away from the traditional ratings system, the report said.

Collateralized loan obligations are probably among some of the most difficult assets to price and rate.  S&P handles a boatload of them.  They also have a history of being wrong.

More than 14,000 securitized bonds in the U.S. are rated AAA by S&P, backed by everything from houses and malls to auto- dealer loans and farm-equipment leases, according to data compiled by Bloomberg.

S&P has said it made mistakes in structured finance since the crisis including misunderstanding cash flows and using conflicting methods to analyze the securities. Its owner, New York-based McGraw-Hill Cos., depended on credit ratings for 27 percent of its $6.19 billion of revenue last year, down from 33 percent of $6.77 billion in 2007, Bloomberg data show.

“These are errors that could cause airplanes to crash if this was aerospace engineering,” said Sylvain Raynes, a principal at R&R Consulting in New York and a former analyst at Moody’s Investors Service.

There really is a need for reform and regulation in the way ratings institutions operate.  That’s unlikely to happen as long as Republicans have any say in Congress and financial institutions hold sway in places like the U.S. Treasury.