Was it greed, negligence or something else that caused the Big Three credit rating agencies , Standard and Poor's, Moody's and Fitch, to grossly overestimate the safety of bonds, which encouraged investment in extremely risky subprime mortgage instruments and sparked the 2008 financial meltdown. It appears we're about to find out, because the Justice Department Monday filed a lawsuit against S&P, charging it with fraud.
Risky bonds have always been for sale. But they were rated as such, with lower ratings and warnings like "highly speculative" and "substantial risks." Investors, public and private, domestic and foreign, knew what they were getting, knew the risk of the issuer going bust and their not getting their money back.
The difference in this case was that the agencies were handing out AAA ratings , the highest, for worthless bonds.
Why? Conflict of interest is one reason. The rating agencies are paid by the issuers of bonds and want to please them.
Competitive pressure is another. S&P relaxed its rules only after Moody's, its main competitor, did; had it not, it risked losing business to Moody's. (If another government lawsuit against Moody's isn't coming, one should be.)
S&P will argue at trial that it is a private agency that made an honest mistake, and that the buyer should beware. But small investors, at least, can't be expected to do such complicated research themselves. If the government doesn't want to rate bonds itself, it should at least have strong regulations, and go after fraud when it occurs.
It should also do what it has so far failed to do: prosecute some of the big financial institutions that packaged and repackaged the bad debt. They have far more resources than the rating agencies , especially after receiving government bailouts.