Normally, I'm not on Attorney General Kamala Harris' side. But I applaud her decision to join the U.S. Department of Justice and 16 other states in a civil suit against the Standard and Poor's rating agency.
Harris alleges, correctly in my opinion, that the grossly inflated ratings S&P assigned to worthless mortgage securities fraudulently lured the state into investments that ultimately drained $1 billion from the California Public Employees Retirement and the California State Teachers Retirement systems.
I have more than a passing interest in the outcome of the DOJ and California's litigation. First, I'm a STRS member. Second, like millions of other Californians, S&P's enabling role in the mortgage crisis delayed the sale of my home for years. When my house finally sold, it was at a distressed level. Third, in my former career as a Wall Street banker, I had worked with S&P when the firm's ratings were the critical barometer in judging a corporation's credit worthiness. But that was long ago, when S&P had standing — and before the bank that I worked for, Merrill Lynch, disappeared overnight after having lost billions speculating in worthless securities.
As a general rule, an investor should manage his money under what's known as "caveat emptor" — "let the buyer beware." But unless investors stick to either blue chip stocks or 100 percent government-backed money market instruments like treasury bills, a certain amount of risk is always present.
Enter S&P. Time was that S&P hired and trained some of Wall Street's most diligent, expert credit analysts. When S&P rated a security AAA, investors could proceed without fear of sustaining crippling losses. Analysts relied on their experience and time-tested financial ratios, which they calculated using the good, old-fashioned green eyeshade method of putting pencil to paper and tallying the result on a desktop calculator.
But high-risk mortgage bonds aren't General Motors or Amoco. Major industrial companies like GM are familiar to investors. They drive cars and put fuel into them. But the new-fangled mortgage bonds' value, or lack thereof, was well beyond what a typical buyer could understand.
Enter S&P again — which promptly rated most bundled mortgage offerings as AAA, and thus gave them the official seal of approval without which no person would have invested a dime. The agencies used computer models to help them reach their wildly optimistic conclusions — the same models that gave favorable ratings to Enron before its collapse.
In the end, S&P played a starring role in, temporarily at least, destroying the world's economy. Trillions were lost; some small investors were wiped out.
In the meltdown's aftermath, S&P insisted that its ratings represented only opinions and that those who invested should have proceeded more cautiously. S&P disingenuously hid behind the First Amendment. But in 2009, a New York Federal Court ruled that the ratings were not merely opinions, but instead misrepresentations caused by either fraud or negligence. The court's decision paved the way for the DOJ and Harris' suit.
S&P faces an uncertain future. DOJ is seeking $5 billion in damages and contends that S&P purposely avoided relying on more updated models because they would have produced unfavorable results. For S&P, lower ratings meant fewer customers and billions in lost fee income. Typically, S&P charged $150,000 to $750,000 per transaction.
The suit further claims that S&P knew about the fraud it perpetrated. Internal emails exchanged by S&P staff as early as 2005 indicated that they anticipated a "crisis."
The feds' suit is too little, too late. But at least it will provide some accountability — although not enough to stave off another greed-fueled collapse sometime down the road.
Joe Guzzardi retired from the Lodi Unified School District in 2008. Contact him at firstname.lastname@example.org.