To Stop Next Crisis, Make S&P Own Up to Fraud in Settlement

On Monday, David O. Carter, a U.S. District Court Judge, is expected to formally approve a proposed settlement between the Department of Justice and Standard & Poor's over the latter's credit ratings. The Department of Justice accused S&P of misleading investors by issuing fraudulent credit ratings on residential mortgage-backed securities and collateralized debt obligations sold between September 2004 and October 2007.

Under the terms of the settlement, S&P would pay $1.375 billion to the U.S. Treasury, 19 states and the District of Columbia. The DOJ does not seek an admission of guilt. As noted by the department, all S&P agreed was to "formally retract an allegation that the United States' lawsuit was filed in retaliation for the defendant's decisions with regard to the credit of the United States."

Allowing a deal without an admission of guilt would have ramifications well beyond the parties to the case. It would protect the monetary interest of a narrow set of persons, short-circuit the justice process, fail to protect the interests of DOJ and the general public, do little to protect victims of other financial crimes, and damage the country's long-term economic prospects.

Until the true nature of the financial crisis is revealed, the economy and financial markets will remain fragile and effective solutions to the problem cannot be implemented. Unless one can focus on the true cause of a problem, one's ability to correct the problem is limited. If a mechanic tells you that a problem with the transmission is the reason your car will not move, when in reality, you are simply out of gas, even if you "fix" the transmission, your car will remain immobile. So it is here.

Without an admission of guilt, transaction costs — in the broad economic sense of the costs of participating in a market — will increase in financial markets. Investors will seek ways to protect themselves from what they know are biased ratings. They will do so by investing in all manner of derivatives and other insurance policies. As we know from the portfolio insurance tools offered by AIG, Lehman Brothers and Bear Stearns, these policies are only as good as the institution writing them. In times of maximum stress, when you need them most, these policies are most likely to fail.

Rather than subject the financial marketplace to this risk, simply getting an admission of guilt will provide the certainty that investors need to make informed decisions about the validity of credit ratings. If the defendant is required to admit guilt based on the legal requirement that credit rating agencies have the ability "to operate independently of economic pressures," the renewed commitment to competition this signals would lower the probability of another financial crisis.

An admission of guilt would make it more likely that competition in the credit rating industry will increase. Demand-side (clients) and supply side (new firms) pressures would increase. S&P would face significant scrutiny from others damaged by the faulty ratings, but unable to participate in DOJ's lawsuit. Some institutional clients would have a formal reason to seek alternatives. This in turn would open the door for new firms to go through the process of being certified as a credit rating agency, a time-consuming and expensive process to say the least. An admission would also make it marginally more likely that new firms going through that process will actually be registered as rating agencies, since the Securities and Exchange Commission would be under pressure to facilitate alternatives.

S&P was able to issue low quality or even false ratings, with no consequences or fear that new credit rating industry entrants would provide ratings that are more accurate. Since new entrants cannot easily access the market, S&P had no reason to fear price competition, either. S&P was free to charge, within limits, what it wanted. With more competition, the public would be better protected. An admission of guilt would signal that the government is less committed to protecting credit rating industry incumbents than before.

I am fully versed in a recent appeals court decision regarding overview of settlement details by courts. In that case, a federal appeals court overturned U.S. District Judge Jed S. Rakoff's decision to reject a $285 million settlement between Citigroup and the SEC.

At issue was a proposed settlement resulting from claims that the bank misled investors in 2007 when it sold mortgage-related securities while the bank simultaneously bet against the debt as the U.S. housing market began to falter. Rakoff, in reviewing the terms, disagreed with a longstanding SEC policy of letting many corporate defendants settle without admitting or denying the agency's charges.

But this case is different. The appeals court decision concerned the SEC, charged with oversight of a portion of the domestic financial sector. In the current case, the plaintiff is DOJ, charged with oversight of all sectors. The difference in scale and scope is significant. (Please note that I am not suggesting the court establish the truth of the allegations against Standard & Poor's.)

Getting an admission of guilt now has higher long term economic value for the country, and all of its government agencies. Thus, while portions of the proposed settlement agreement may be fair and reasonable for DOJ, the broader public interest as represented by all government agencies would, in fact and in practice, be disserved under the settlement proposal.

Without meaningful reform, which in this case means an admission of guilt, another financial crisis, even more severe than the last, is almost certain to occur in the next seven to nine years. Judge Carter has the ability to influence the probability that this will occur.

William Michael Cunningham is a University of Chicago-trained economist. He filed a friend-of-the-court brief with the U.S. District Court for the Central District of California in this case. A social investor adviser in Washington, he is the author of "The Jobs Act: Crowdfunding for Small Businesses and Startups."