The Justice Department said Tuesday it could seek more than $5 billion in damages from Standard & Poor's, the nation's biggest credit ratings company, a day after it sued the company, alleging that S&P defrauded investors by giving triple-A ratings to risky subprime mortgage investments.
The ratings business got started a century ago, when John Moody set up a company to rate railroad bonds for investors. Over the years, Moody's, S&P and Fitch, their smaller rival, expanded into other kinds of securities such as corporate and municipal bonds.
Josh Rosner of the consulting firm Graham Fisher and Co. says the ratings companies owed part of their growth to the government. He says regulators such as the Securities and Exchange Commission required anyone selling a security to first get a rating from a designated ratings company. The problem was that the SEC was particular about which companies got designated to do the ratings.
"Until you were designated as a rating agency, it would be very difficult to demonstrate that you have been a rating agency," Rosner says. "So there was this circular logic embedded in the process of approving new entrants."
As a result, the ratings business became a kind of closed shop, an oligopoly dominated by a few big players. For years, the ratings companies made money by writing up reports and selling them to investors.
Economist Lawrence White of NYU's Stern School of Business says he believes the invention of photocopying machines changed that. Suddenly, ratings companies had to worry that investors could share illegal copies of the research.
"The rating firms were afraid that the [copy] machine would do to the rating business what the Internet would do to the recorded music business three decades later destroy the business model," White says.
So the ratings companies made a fundamental change: Instead of charging investors for their research, they began charging the companies that issued the securities they were rating. It meant that the ratings companies were dependent on big Wall Street firms for revenue.
"So a major investment bank had a much more potent threat," White says.
The threat: If you don't give me a better rating, I'm going to take my business elsewhere.
That became a big problem during the housing boom. U.S. Attorney General Eric Holder said Tuesday the ratings companies were so dependent on Wall Street money that they ignored warning signs about the mortgage meltdown.
"Put simply, this alleged conflict is egregious and it goes to the very heart of the recent financial crisis," Holder said.
In the years since the housing bust, Congress has tried to reform the ratings business. The Dodd-Frank financial reform bill seeks to encourage competition in the ratings business, but Rosner says the bill also seeks to lessen the role ratings companies play in the financial markets.
"Rating agencies do still have a business, do still have a foothold," he says. "The goal is to eat away at that over time."
Rosner says the reforms, however, don't go far enough. That hasn't been a problem so far because the market for mortgage-backed securities is still shut down. But if another housing boom occurs, he says, there's nothing to stop another flood of bad mortgage bonds from surging through the economy.