Standard and Poor's: Downgrade Backlash?

Aug. 18, 2011 — -- Has Standard & Poor's downgrade of U.S. debt from AAA to AA+ made the ratings agency a lightning rod for critics and regulators?

The Justice Department is reportedly investigating whether S&P improperly rated dozens of mortgage securities before the financial crisis, and the city of Los Angeles has withdrawn its S&P contract to rate its $7 billion investment portfolio.

"Quite frankly, we just don't want to be associated with [Standard & Poor's] anymore based on that decision. We think it was irresponsible and just excessive," Thomas Juarez, the city's chief investment officer and assistant treasurer, told The Bond Buyer. The city council's budget and finance committee was told of the cancelled contract on Monday.

The Justice Department reportedly began investigating whether S&P improperly rated dozens of mortgage securities before the ratings agency issued its downgrade of U.S. debt on Aug. 5, according to the New York Times.

Bob Litan, deputy assistant Attorney General at the Department of Justice from 1993 to 1995, said people are leaping to the conclusion that the reported investigation is a result of the U.S. downgrade.

"Having been at the Justice Department, I don't think the department behaves that way. I think this is almost certainly a coincidence. It's just the way these things happen," Litan, now vice president of research and policy at the Kauffman Foundation, told ABC News.

Although it is routine for the chairpersons of congressional committees to send letters to the Justice Department to encourage investigation into issues, Litan does not think the investigation would proceed in response to the downgrade.

"I can't believe any calls were made to rush through the announcements as a way of retaliation," he said.

Litan also said that he does not think the Justice Department is singling out Standard and Poor's among the ratings agencies.

"My guess is that if the Justice Department is investigating one agency, it's investigating them all," Litan said. "Given what we all know now in the run-up to the financial crisis, all the ratings agencies were doing similar things in rating these securities. If S&P is guilty of something I find it hard to believe the others wouldn't be too."

Members of Congress have criticized the ratings agencies for their role in giving top ratings to mortgage-backed securities before they crumbled and contributed to the financial crisis.

"The credit rating agencies failed spectacularly in the years leading up to the financial crisis. A government seal of approval for credit rating agencies led to a mispricing of risk and the subsequent collapse in market confidence," Rep. Spencer Bachus, R-Ala., said during a House financial services oversight subcommittee hearing on July 27.

Deven Sharma, S&P president defended his ratings agency during the hearing.

"Importantly, S&P's ratings do not make recommendations to buy, sell or hold a security," Sharma said in his prepared remarks. "Rather, they simply provide the market with a forward-looking view based on analysis that different market participants — whether they be investors, issuers, or regulators — may choose to use as part of their own assessment of the credit risks attendant to a particular security or entity."

Critics in and out of government returned fire at the credit rating company rhetorically after it downgraded the U.S. Competing ratings agencies Moody's Investors Service and Fitch Ratings have affirmed the country's AAA rating. Most recently, Fitch reaffirmed the rating on Tuesday.

Even as S&P issued new rating downgrades from AAA to AA+ against municipal entities backed by federal leases in Miami, Atlanta and Tacoma, Wash., according to Bloomberg.

A committee aide said the Democrat-controlled body "is looking into the issue and gathering more information" but emphasized that so far there was no official committee probe or investigation.

Standards & Poor's Rating Service has been grading corporate bonds for 90 years. Today, it has 1,226 employees and does $75 million in business every year in more than 20 countries.

But Jules Kroll, one of its main critics, who started his own, smaller rating service, says S&P is not big enough to judge 100 countries because it has only about 100 actual analysts.

"Doing analysis of the economy of the United States and its likelihood of default is something that requires enormous resources that go far beyond the resources of S&P," Kroll said.

S&P missed the Enron crisis, giving the failed company high ratings until the day it went bankrupt. In 2008, it gave an AAA rating to toxic waste mortgages. Then, it gave an A rating to Lehman Brothers just before the investment bank went under. It also failed to sound the warning about the serious economic troubles in Ireland, Spain and Greece.

New York University professor Lawrence White said S&P had a valuable opinion, it just carried too much power.

"I wish that S&P were just another voice among the multitude of voices rather than this specially enhanced voice," White said.

Despite the anger at S&P, critics have argued that it is merely the messenger, and that the government is to blame for not getting its fiscal house in order sooner.

"If we were running our affairs properly, we wouldn't have to worry about S&P, Moody's and Fitch," said Paul O'Neill, referring to the three major rating companies. O'Neill served as Treasury secretary under President George W. Bush.

ABC News' Jim Avila, Sunlen Miller, Michael S. James and Eileen Murphy contributed to this report.