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S&P faces lawsuit over high credit ratings: Why now?

A sign for Standard & Poor's rating agency stands in front of the company headquarters in New York, September 18, 2012.

Story highlights

  • U.S. government lawsuit against S&P would be first for a credit ratings agency
  • S&P parent company, McGraw-Hill, plunged 13.78% in Monday trading
  • NYT: $1 billion settlement talks recently fell through between S&P, Justice Dept.
  • S&P: Justice Department lawsuit 'without factual, legal merit'

In a first for a U.S. credit ratings agency, Standard & Poor's has received official notice from Washington that it will face a civil lawsuit over imprecise ratings -- now criticized as being too high by analysts, U.S. lawmakers and even S&P itself -- of mortgage-backed investments that eventually contributed to the 2008 financial crisis.

Many of those investments received AAA ratings, a grade which implies highest safety and least risk, but imploded as the U.S. housing bubble burst.

As S&P awaits further word from the U.S. Department of Justice, ratings agencies Moody's and Fitch will be watching to see if they are next.

Standard & Poor's parent company, McGraw-Hill Companies, plunged 13.78% in Monday trading, after investors learned of the Department of Justice's intent to file suit. The company's share price fall was its biggest one-day drop since the stock market crash of 1987.

It is unclear as to why S&P is the first to be targeted but according to a recent New York Times report, settlement talks between the ratings agency and the Department of Justice fell through in the past two weeks. The article also reported that prosecutors demanded S&P pay a $1 billion penalty and admit to wrongdoing.

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In a statement, S&P has said the expected Department of Justice is "entirely without factual or legal merit."

    Who are the credit rating agencies?

    The "big three" are Standard & Poor's, Moody's Investor Services and Fitch Ratings. All originated in the United States, although Fitch has headquarters in New York and London.

    What do they do?

    Before you can get a credit card, banks run a credit check on you. Similarly, the ratings agencies run credit checks on companies, countries and financial products -- and banks themselves.

    The agencies assess their ability to pay off loans or investments and then rate them on a sliding scale, ranging from AAA to D. In the case of government bonds, anything that slips to BB+, as was the case with crisis-hit Greece, is considered a "highly speculative" investment, or "junk bonds" in the parlance of the markets.

    Why do the agencies wield such power?

    Investors across the world look to credit ratings agencies to judge where to place their bets in the market. For governments, the ratings agencies have a lot of power over the popularity of bonds: cash given to governments like Greece by investors that, over time, will pay a return on the original investment -- unless the government defaults.

    The downgrade of Greece signaled Standard & Poor's belief that Greece has a higher likelihood to default on investments. It caused investors to lose their appetite to invest in bonds from Greece, which then imperiled the nation's ability to pay down its deficit.

    How are ratings agencies paid?

    Historically, they were created to give investors an unbiased assessment of investments and investors paid for access to the ratings. In the 1970s, however, credit rating agencies started charging the issuers of new investments fees for ratings. In 1975, U.S. legislators -- fearing a proliferation of unscrupulous ratings agencies -- designated Standard & Poor's, Moody's and Fitch as the only ratings organizations banks and brokers could use to evaluate the credit worthiness of their products.

    Since 2011 however, European regulators have begun to push back against U.S. ratings agencies, blaming them for adding volatility to the sovereign debt crisis by lowering their ratings of troubled eurozone nations -- thereby pushing up borrowing costs.

    What are the complaints against the firms?

    Critics complain the agencies have lost their ability to independently judge the risk on certain investments -- especially in light of AAA ratings given to mortgage-backed securities that imploded when defaults on U.S. home loans shot up, triggering the 2008 financial crisis. Critics also note that the agencies are paid by the very entities they rate, raising questions about their trustworthiness.

    Lawmakers in the United States, the European Union and other countries around the world are now reviewing regulations on the credit ratings agencies. Credit ratings agencies, too, have revamped their procedures and have argued their ratings are merely opinions -- it's up to the markets to decide.

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