The Justice Department should resist any overtures from Standard & Poor's Ratings Services to settle the civil suit that it is bringing against the agency. The case should go forward to trial because only in a courtroom will S&P's actions in rating mortgage-backed securities in the lead-up to the 2008 financial crisis be fully disclosed.
Only then will investors be able to determine whether the company put profit ahead of principle when determining the ratings of those securities. Only then will they be able to determine how much weight to place on the ratings of fixed-income securities by such agencies in the future.
Whether the Justice Department wins or loses the suit, the disclosure of ratings agency practices and methods, and the degree of influence wielded by the investment banks paying for the ratings, likely will result in better practices, better oversight by management and better disclosure, to the benefit of investors.
Reportedly, the Justice Department and S&P have discussed a possible settlement for several months, but S&P balked at the size of the penalties that the department sought. S&P might change its mind when it considers the $5 billion penalty that the Justice Department is seeking and the damages for which the states and private investors are lining up to sue should it lose the Justice Department case.
But even though it faces several hurdles, the Justice Department should push ahead to trial.
The department has been investigating whether S&P managers weakened company standards for rating mortgage-linked securities. According to reports, the government is focusing its case on 30 collateralized debt obligations issued in 2007 that plunged soon after they were sold to investors.
The government thinks that the ratings agencies in general, and S&P in particular, played a large part in allowing the mortgage market to become overheated through their inappropriate ratings, contributing to the magnitude of the crisis when the housing bubble burst.
The triple-A ratings issued on mortgage-backed securities that contained subprime mortgages allowed even conservative investors, such as pension funds, to buy them, increasing the pressure on housing prices.
Among the difficulties that the Justice Department faces is that bond ratings are sold as opinions, so they are protected by the First Amendment. Courts have rejected suits in the past because of that protection.
However, the protection might not apply if the firm ignored its own standards in trying to protect its profits or if it knew that information supplied by the investment banks seeking the ratings was misleading.
In addition, the Justice Department reportedly has e-mails and other records that seem to show growing concerns among S&P analysts about the health of the housing market even as the firm continued to pursue and issue ratings on mortgage-backed securities. Federal prosecutors think that S&P management resisted downgrading many of the securities out of fear of losing ratings business to competitors.
S&P argues that the Justice Department has cherry-picked the e-mails on which it is basing its case and that its misplaced complacency about the housing market was shared by government agencies and other financial institutions. S&P also notes that as mortgage delinquencies rose, ratings were revised, and in 2006, it downgraded 400 residential mortgage-backed securities.
That said, it is now obvious that S&P and others were too smug in 2007 and 2008, and should have been more cautious in issuing triple-A ratings on CDOs as the housing market heated up.
They should have been more curious about the quality of the mortgages underlying the CDOs on which they were issuing such ratings.
A trial likely will show whether S&P was just carried away by the euphoria surrounding housing or whether it was incurious because it was good business to be so.
Whatever the outcome of the trial, the bond-rating business likely will be changed, and investors likely will place less weight on the ratings than they have in the past.
However, it is important to remember that S&P and the other ratings agencies didn't create the housing bubble and the financial crisis. Many had a role, including the government and some of its agencies.