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U.S. suing S&P may be very bad for investors and democracy

By Peter Morici
web posted February 11, 2013

The Justice Department is accusing S&P of defrauding investors with optimistic ratings of mortgage backed securities and derivatives prior to the financial crisis. While investors are entitled to answers about those conflicts, compensation and reforms, the Attorney General and President, by singling out S&P, instead of other bond raters, appear to be engaging in political vengeance and put freedom of speech at risk.

In 2011, S&P, Moody's and Fitch were accused by a Senate Committee of giving overly rosy ratings on mortgage backed securities in the years prior to the financial meltdown of 2008, and then contributing to the severity of the crisis by hastily downgrading hundreds of securities after the housing bubble burst.

Notably, S&P, alone, in August of 2011 downgraded U.S. government bonds—causing the President considerable embarrassment at a time when his reelection was far from certain. And, this downgrade will raise U.S. borrowing costs, and ultimately curtail federal spending and the President's progressive agenda, when the Federal Reserve deems appropriate to end quantitative easing, which is artificially depressing all interest rates.

Often, federal prosecutors, when several firms have engaged in unsuitable practices, will single out one to obtain damages and reforms, and then use that settlement to obtain concessions from the others; however, the selection of S&P certainly creates the appearance of sovereign and political abuse.

By any reasonable measure, U.S. debt and spending has reached an unsustainable level. Simply, the tax increases necessary to bring the federal deficit down to a level that would stabilize the national debt as a percentage of GDP, would certainly cause a deep recession, similar to conditions in Italy or Spain, and not yield the anticipated revenues. Hence, spending, in particular entitlement spending, must be cut; however, the President has neither admitted this situation nor shown any inclination toward real entitlement reform.

By not downgrading U.S. debt, Moody's and Fitch, have demonstrated the same neglect to investors that all three bond rating agencies practiced during the mid-2000s—now, the Justice Department lets them pass by targeting S&P.

At the heart of the matter is the bond rating agencies business practice of charging fees to the firms, state and local governments who issue bonds, and financial houses that create derivatives. The resulting conflict of interest encourages overly rosy ratings that lag market assessments of company and government financial health.

The rating agencies have refused to return to change this business model—they find the present too lucrative to put their public responsibility above profits—and this requires a legislative solution.

The bond rating agencies have clung to a First Amendment defense, but that has terrible public policy foundations. No individual may rely on free speech to knowingly deceive another for the purpose of financial gain—that is the textbook definition of fraud—and no reasonable assessment of the public or investor interests can justify that defense.

Yet, by singling out S&P—the firm that downgraded U.S. government debt—the Attorney General and President has failed to acknowledge their own conflict of interest and create the appearance of retribution.

In other areas, for example broadcast news coverage, the Administration has pressured networks it believes demonstrate a conservative bias, but has kept its hands off those demonstrating similar preferences for its more liberal policies.

By suing S&P, and not Moody's and Fitch, the Attorney General and President have failed to exhibit the sovereign restraint necessary to sustain the open and fair criticism of the government to sustain American Democracy, and place constitutional protections at grave danger.  ESR

Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and widely published columnist.






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