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SEC may act against S&P for ’07 debt rating

Could be 1st step targeting industry

By Marcy Gordon
Associated Press / September 27, 2011

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WASHINGTON - The Securities and Exchange Commission is considering taking civil action against Standard & Poor’s for its rating of a 2007 mortgage debt offering. Such action could be just the first shot in a legal assault against the major credit rating agencies.

The three major agencies - S&P, Moody’s Investors Service, and Fitch Ratings - gave high ratings to mortgage investments that turned out to be worthless and contributed to the 2008 financial crisis.

If the SEC charges S&P with violating securities laws, it would mark the first time it has brought an enforcement action against a top rating agency.

McGraw-Hill Cos., which owns Standard & Poor’s Ratings Services, said yesterday in a regulatory filing that the SEC staff had told the company it is considering recommending that the agency act. The SEC’s staff said it may recommend to the agency’s five commissioners that they seek a civil fine and restitution.

The formal notice from the SEC’s enforcement staff gives S&P a chance to make a case that there is no basis for charges. S&P said it will continue to cooperate with the SEC.

Regardless of the outcome of the S&P case, the entire rating agency industry may be facing enforcement actions related to the financial crisis.

“It’s a dark cloud on the horizon because this could be the first of many,’’ said Anthony Sabino, a law professor at St. John’s University in New York.

The SEC has been investigating the actions of big Wall Street players in the run-up to the financial crisis, which plunged the economy into the deepest recession since the 1930s.

The agency has already charged several securities firms over their sales of complex mortgage investments. Last year, Goldman Sachs paid $550 million to settle fraud charges - the largest penalty against a Wall Street firm in SEC history.

Before the financial crisis erupted, the three big rating agencies gave AAA ratings to trillions of dollars in securities linked to high-risk mortgages. Once home loan delinquencies soared and the housing market went bust, so did those investments. Major banks absorbed tens of billions in losses.

Critics note that the rating agencies face an inherent conflict of interest: They are paid by the institutions whose products they rate. The agencies have been accused of issuing unduly high ratings before the crisis because of pressure from banks whose business they wanted.

New SEC rules mandated by the financial overhaul law passed last year require the agencies to provide more details about how they determine each rating.

The SEC’s own reputation has been battered, in part, by its failure to detect Bernard Madoff’s Ponzi scheme over the nearly two decades in which it operated. Action against S&P or other rating agencies would allow the SEC to show it is cracking down on contributors to the financial crisis.

The SEC’s notice involves the rating of a 2007 collateralized debt offering, or CDO. CDOs are securities that contain many underlying mortgage loans.

A CDO generally gains in value if borrowers repay. But if they default, a CDO loses value. Soured CDOs have been blamed for deepening the 2008 financial crisis. And the big ratings agencies have been accused of being lax in rating CDOs.

James Cox, a Duke University law professor and securities law expert, said the difficulty in proving the case is showing that the rating agencies believed the investment was poor and then decided to give it a superior rating.

In addition to its inflated ratings before the financial crisis, S&P has been under fire since its downgrade of long-term US debt in August. Its president stepped down last month.

The news of possible SEC legal action comes two weeks after McGraw-Hill announced plans to split into two public companies. One would focus on education, the other on financial markets, including the Standard & Poor’s unit. The move had been expected, in part because investors have pushed the New York company to boost its stock price, which is off more than 40 percent since 2006.