U.S. Justice Department Probing S&P Mortgage-Backed Securities Ratings System

The U.S. Justice Department is investigating credit rating agency Standard & Poor's (S&P) for allegedly overrating mortgage-backed securities, whose high rates of default in certain investment classes set in motion the 2008 financial crisis.

The U.S. government was looking into whether analysts for S&P, a unit of McGraw Hill Co. (MHP), wanted to give lower ratings to the mortgage securities, but were overruled by business managers. S&P, like other ratings agencies, collects fees from issuers for rating securities, The New York Times reported Thursday.

The Times also reported that the Securities and Exchange Commission is also investigating S&P, and might be looking into rating agencies Moody's Corp. and Fitch Ratings, concerning mortgage securities.

Both public policy and private sector officials have expressed concern that ratings agencies overrated mortgage securities during the bubble period.

During the housing bubble/housing boom years, 2002-2007, S&P and other agencies issued high ratings on bundles, or groups of mortgages that in other eras would have been considered higher-risk. That made the mortgage notes appear less-risky. When combined with other practices by mortgage lenders, mortgage brokers, and borrowers, loan risk rose considerably throughout the system, with many lending problems obsured by banks' willingness to refinance mortgages that became problematic.

When the housing bubble burst, many banks stopped granting certain categories of refinancings, triggering a large increase in defaults and foreclosures, lowering the value of mortgage-backed securities linked to these mortgages.

The S&P period under investigation occured years before S&P's controversial decision to downgrade the U.S. Government's credit rating earlier this month, but the mortgage-backed securities rating controversy will probably only add to sentiment in legislative circles about the need for reform in the ratings sector.

Political/Public Policy Analysis: The housing bubble period was riddled with problematic loan practices, from lender to borrower. Further, as the view from here has argued previously, if federal regulatory officials determine that substantial law violations occurred, it provides more support for Congress to establish two or three public, independent ratings agencies.

What the U.S. needs is a system in which those who rate bonds, and mortgaged-back securities etc. are not paid by those they are rating -- and two or three, federally-funded independent agencies would be a good first step.