The security in question is “Delphinus,” a $1.6 billion collateralized debt obligation, or CDO, that S&P granted a AAA credit rating to in 2007. CDOs are financial packages that contain a number of financial bonds, such as mortgage-backed securities or even other CDOs. Though composed of risky securities that derived their value from subprime mortgage loans, S&P, along with Moody’s Investor Services and Fitch Ratings, nonetheless granted the packages with AAA ratings, a rating that traditionally signals almost complete confidence in the asset.
The SEC investigation is not the first public scrutiny of S&P’s rating practices. In August, it was reported that the Justice Department was also investigating S&P, specifically if it knowingly gave false ratings to “toxic” assets, as the mortgage-backed financial products have now been labeled.
Central to that question – did S&P overrate those bonds – is the way that ratings agencies are compensated for the very ratings they provide. A hypothetical example would be a new financial product from Goldman Sachs: Goldman Sachs, wishing to sell the product in confidence to its investors, asks S&P to rate the product; the rating, as the business ethics denote, should be based on the quality and soundness of the product; the problem, though, is that Goldman Sachs is paying S&P for that very rating.
Hence, the SEC, Justice Department and countless journalists and consumer advocates have questioned the intent of the ratings agencies, and if they were simply offering AAA credit ratings to continue reaping large profits.
And as the New York Times reported yesterday, rating financial instruments was quite profitable for S&P. In 2006, S.& P. made $561 million in revenue rating mortgage bonds, charging anywhere from $30,000 to $750,000 to rate each deal. Factor in that in the three years before the crisis, S.& P. rated 5,500 mortgage bonds and 835 C.D.O.’s, and you’re looking at quite a bit of money.
In a statement addressing the investigation, McGraw-Hill stressed that S&P has not been formally charged with any wrongdoing, and the SEC inquiry is just that, a harmless investigation of the firm’s business dealings. However, as the Los Angeles Times points out, if the SEC does charge S&P with any wrongdoing – which could include fines, civil penalties and payments to defrauded investors – it would be the first credit ratings agency to face such action, and that fact is generating notable attention.