US Sues S&P Over Sub-Prime Vehicle

The genesis of the Global Financial Crisis was the realisation that many banks and financial institutions were heavily subscribed to sub-prime mortgages and consequently at great risk if borrowers defaulted. The sub-prime concept was that money could be lent to borrowers with less than stellar credit histories if they paid a premium interest rate. Most of these borrowers would be good for their repayments, but inevitably some would default. The innovative approach of some financial whizz kids was to “securitize” these loans by bundling them together and selling them on as an investment product. The idea being that the “product” would be able to withstand individual defaults since the vast majority of the underlying assets would go to term on their mortgages.

These vehicles were known as Collateralised Debt Obligations (CDO) and the risk associated with investing in them was assessed by the ratings agency as being top-tier, investment grade. The ratings agencies get commission for providing this service, so they are always likely to be open to a charge of acting in their own self-interests in making such an evaluation, but that is how the system has evolved. In the cruel glare of hindsight, this has to be one of the poorest judgments in financial history.

The US Justice Department has filed a law suit against one of the biggest ratings agencies, Standard and Poor’s (S & P), alleging that they deliberately overlooked the risk associated with OCDs.

S & P have suggested that the move was taken because of their decision to downgrade American sovereign creditworthiness from AAA to AA+ because of the debt situation and (then) and impasse in Congress over the debt ceiling. Let’s hope they can come up with a more robust defence when the matter goes to court. If the suit succeeds, it is likely that many other nations and investors may decide to take similar actions against S & P and the other ratings agencies.