Standard & Poor’s role in the 2008 financial crisis

November 2019

Gregor Frowein

In 2008, the financial markets in New York came to a halt. After almost seven years of a low- interest rate introduced in 2001, ‘cheap money’ had taken over financial markets in America, resulting in a boom of investments and loans. The apparent dream of a working-class citizen being able to afford a new house rapidly engulfed the country and resulted in mortgages being distributed to anyone wanting. However, few realised the implications of a lack of due diligence and ensuring citizens had the means to repay them. The result, as stated by the U.S. treasury, was a loss of 8.8 million jobs and over 19 trillion dollars in the households of American citizens (The Department of the Treasury, 2012). The subsequent decline in GDP of 5 per cent, underlines the severity in the failure of institutions.

S&P’s role in the crisis

One such institution is Standard & Poor’s, or more accurately, Standard & Poor’s Global Ratings division. Although the official inquiry report into the financial crisis states that multiple institutions played their part in the crisis and could have avoided the collapse, one might argue that not all institutions had the ability to prevent the crisis (The Financial Crisis Inquiry Commission, 2011). Mortgage companies such as Fannie Mae or Freddie Mac may easily be held responsible for their greed. However, another argument may be put forth for the liability of rating agencies such as S&P. Investors, as well as institutions, mostly rely on rating agencies to provide accurate, thorough assessments of financial investment products. In the 2008 financial crisis however, rating agencies seemed to do the opposite of what they were expected to do. The reason for incorrectly rating financial products, although highly debated, can be split into three central causes. Firstly, the incentive of high fees paid to S&P as compensation for their ratings which one may argue to impact their neutrality, secondly, the reliance on mathematical models and thirdly, the lack of cooperate governance or oversight. Particularly the last point facilitated a lack of due diligence by replacing it with an urge to maximize ‘ratings per day’ of large financial products such as CDO’s. Even though the weight of each cause may not be apparent, one could come to the conclusion that all factors, at least contributed.

The answer to the question of whether S&P was adequately legally ‘disciplined’ is a rather disheartening one. In 2015, the U.S. government had managed to close a deal with McGraw Hill Financial Inc (S&P’s parent company now S&P Global) for a payment of 1.5 billion U.S. dollars (Viswanatha and Freifeild, 2015). Although a rather large settlement, 1.5 billion would roughly amount to the yearly earnings of the company, one might examine that such a settlement although of high short-term effectiveness, does not generally change a company’s culture in the long run. Therefore, other forms of legal punishment should be considered, such as enhancing compliance, third party overwatch and organisational reform, which can all individually or together, contribute to deterrence.

References

The Department of the Treasury (2012). The Financial Crisis Response in Charts. Washington: United States Government, p.2.

The Financial Crisis Inquiry Commission (2011), The Financial Inquiry Report, Washington: U.S. Government Publishing Office, pp.xxv,68,71,119,121,131.

Viswanatha, A. and Freifeild, K. (2015), S&P reaches $1.5 billion deal with U.S., states over crisis-era ratings, Reuters, Available at: www.reuters.com/article/us-s-p-settlement-idUSKBN0L71C120150203 [Accessed 3 Nov. 2019].