SEC Probes S&P Over Insider Trading; It Should Just Question Its Competence

Last Updated Aug 12, 2011 1:39 PM EDT

Standard & Poor's has proven that it's inept. Now the SEC wants to know if it's corrupt, too. The agency is probing insider trading when what it should be looking at is why it never noticed how bad the raters were at their jobs.

The SEC wants to know if S&P executives acted on inside information about its U.S. credit downgrade report. Given that everyone in the world knew the downgrade was coming, it's going to be pretty hard to prove. S&P started warning the report was coming in April. Then a week ago, the day before S&P released its now very tarnished report, the Dow dropped 500 points. The alleged causes were Spain and Italy going in the tank and rumors of the upcoming downgrade. Can it be insider trading if the whole world has the same information?

What would be suspicious is if S&P execs were making a lot of good trades any time in the last year or so. Not for insider trading purposes, but just because it would be nice to know if they ever showed any business sense.

This is not to single out S&P, Fitch and Moody's have hardly crowned themselves with glory, especially in the area of sovereign debt. Consider:
  • S&P has tracked 15 government defaults since 1975. Of those, the firm rated 12 of the countries single-B or higher one year before the event. S&P's single-B rating is supposed to have just a 2 percent average chance of default.
  • Of the 13 governments rated by Moody's within a year of a default, 11 were rated B or higher. Three were rated Ba (which is what Moody's calls double-B) which carries a 0.77% one-year default rate.
OOOOPS.
It's not like this is news to anyone. The reason investors rely far more heavily on bond yields to handicap default risk is because they do a better job at it.
Still, the SEC never thought to wonder if anyone at the Big Three Raters was capable of doing the job assigned to them. The raters themselves knew they weren't. Naked Capitalism's Matt Stoller dug up this wonderful exchange between two S&P analysts that was released by the House Oversight and Government Reform Committee in 2008:
Rahul Dilip Shah: btw: that deal is ridiculous
Shannon Mooney: I know right -- model def does not capture half of the risk
Rahul Dilip Shah: we should not be rating it
Shannon Mooney: we rate every deal-- it could be structured by cows and we would rate it
Let's not go dissing our friendly milk providers, guys. If the mortgage-backed securities had been bovine structured fewer of them would have been purposefully built to fail.
It is only under the lash of the Dodd-Frank financial reform law that the SEC is finally doing what it should have been doing all along: Be a full-service regulator.
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    Constantine von Hoffman is a freelance writer and writing coach. His work has appeared in outlets such as Harvard Business Review, NPR, Sierra magazine, Brandweek, CIO, The Boston Herald, TheStreet.com, CSO, and Boston Magazine.

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