S&P's settlement announced Tuesday with the U.S. government, 19 states and the District of Columbia marks a public chastening of a major credit rating agency accused of knowingly overrating toxic mortgages that ignited the crisis. S&P and its competitors are crucial gatekeepers that can affect a company's or government's ability to raise or borrow money. In the aftermath of the crisis, federal regulators have imposed some changes on how the rating agencies conduct business.
Yet the fundamental conflict of interest at the heart of the rating agencies' business remains intact: They continue to be paid by the companies whose securities they rate.
"This doesn't fix anything," said Janet Tavakoli, the president of Tavakoli Structured Finance and a former investment banker. "This is just a traffic ticket."
Tavakoli cites a number of problems, including payments that companies and banks make to the agencies for ratings, as well as flawed statistical methods. The government should go further and strip the big rating agencies' national licensing for rating complex securities, she suggested.
The process for companies and rating agencies is akin to having a pitcher choose the umpire, critics of the industry say, and it puts pressure on the agencies to award better ratings in order to secure repeat business.
That's exactly what the government asserts S&P did in ratings on billions of dollars of securities that it issued from 2004 through 2007. The settlement resolves a court fight that began with a Justice Department lawsuit two years ago. S&P was accused of failing to warn investors that the housing market was starting to collapse in 2006 because doing so would hurt its ratings business.
Half the amount New York-based S&P is paying, or $687.5 million, will go to the 19 states and the District of Columbia.
Under the agreement, S&P acknowledged that it issued and confirmed positive ratings despite knowing that those assessments were unjustified and in many cases based on packages of mortgages that it knew were likely to default.
"On more than one occasion, the company's leadership ignored senior analysts who warned that the company had given top ratings to financial products that were failing to perform as advertised," Attorney General Eric Holder said at a news conference Tuesday.
S&P also agreed to retract its earlier allegation that the government had brought the action in retaliation for its downgrade of the United States' credit rating in 2011, a concession that Holder said was personally important to him.
The three big rating agencies — S&P, Moody's Investors Service and Fitch Ratings — have been blamed for helping fuel the 2008 crisis by giving strong ratings to high-risk mortgage securities. The ratings made it possible for banks to sell trillions of dollars' worth of those securities. Some investors, such as pension funds, can only buy securities that carry high credit ratings.
S&P rejects the idea that the rating agencies' current business model is particularly vulnerable to conflicts of interest.
It makes the case that having companies pay for ratings enables those assessments to be made widely available to the public, free of charge, thereby promoting greater efficiency in the bond markets. "Public disclosure of our ratings to a broad audience of market participants means our opinions are subjected to market scrutiny every day," it says.
Under a 2010 mandate from Congress, the Securities and Exchange Commission has enacted a series of rules for the rating agencies.
The new regulations require the agencies to provide more details about how they determine each rating. To address the perceived conflict of interest for rating agencies, the rules bar the agencies' sales teams from participating in the ratings process. Agencies must also review and potentially revise their ratings in cases where an employee was later hired by a company he or she evaluated.
The agencies must file a report each year showing how they monitor ratings, how each rating changed over time, and whether the securities or companies later defaulted.
Critics say a better solution would be to create a government board that randomly assigns agencies to rate companies. Congress debated that idea when it put together the sweeping financial overhaul law in response to the 2008 crisis. But lawmakers pushing the idea were unable to include it into the final legislation.
S&P "got off pretty light considering they helped bring down the world's financial system," said James Cox, a Duke University law professor and securities market expert.
There's no guarantee, say critics like Cox, after the SEC changes and legal action that rating agencies' "slouchy practices won't return."
They see proof in a $77 million settlement signed last month by S&P with the SEC and two states that covers alleged misconduct in 2011 and 2012 — well after the financial crisis and after the new SEC rules for agencies began.
S&P's agreement represents one of the government's key efforts to hold accountable market players deemed responsible for contributing to the worst financial crisis since the Great Depression.
In recent months, the Justice Department and states have reached multibillion-dollar settlements with Wall Street titans JPMorgan Chase, Bank of America and Citigroup over their roles in bundling risky mortgages into securities that were misleadingly sold as safe investments, despite the high likelihood that borrowers would default. Those investments soured when the housing market started to crumble in 2006.
Lawmakers and consumer advocates have also criticized the government in the settlements for failing to hold high-level executives accountable and subject to possible criminal prosecution.
S&P's parent McGraw Hill Financial Inc. said in a statement that the settlement contains no findings of violations of law by itself, S&P Financial Services or Standard & Poor's Ratings Services.
S&P also announced Tuesday that it will pay $125 million in a separate settlement with the California Public Employees' Retirement System to resolve its claims against the company regarding ratings on three structured investment vehicles. The settlement is not subject to judicial approval.
The Justice Department had demanded $5 billion in penalties from S&P when it sued the company in February 2013. The payment of about $1.38 billion to settle the case is less than S&P's revenue in 2013 of $2.27 billion.
Craft reported from New York.