September 18, 2009 / 3:15 AM / 10 years ago

California probes credit rating agencies

SAN FRANCISCO (Reuters) - California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings as he launched an investigation of whether they broke state law with the ratings they provided mortgage-backed securities.

“These agencies gave their seal of approval, their highest ratings, to underlying securities that were highly dangerous and in fact wreaked havoc on the lives of millions of people,” Brown said at a news conference.

The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition.

“The agencies have been coddled and protected,” Brown said. “It’s time we smoked ‘em out.”

Agencies claim first amendment freedom-of-speech protection for their ratings, but courts have given mixed support. A federal court in early September allowed a lawsuit against agencies claiming such protection to go forward.

Supervising Deputy Attorney General Kathrin Sears, who heads the probe, said the agencies had hidden behind the First Amendment, in her view. The investigation was just beginning, and the state needed to review the agencies responses, she added.

The agencies must respond to subpoena questions and requests for documents by October 19, but could seek an extension, she said.

S&P, owned by McGraw-Hill Companies Inc. MHP.N, said it had not received a subpoena and could not comment.

Fitch, owned by Fimalac SA LBCP.PA, said it expected to provide information once it received a request, and Moody’s Corp (MCO.N) said it had received inquiries from state and regulatory authorities about its ratings and would cooperate as appropriate after reviewing them.

SUBPRIME CRISIS PROBE

At the peak of the housing boom, the agencies gave their highest ratings to complicated financial instruments, including securities backed by subprime mortgages, making them appear as safe as government-issued Treasury bonds, Brown’s office said.

But California’s economy slumped as house prices fell sharply in the past couple of years. Its unemployment rate has hit record highs and government faced a major crisis as tax revenue plummeted.

The purchases of the securities helped fuel the housing bubble by providing funds for lenders to “issue ever-riskier subprime and other toxic mortgages,” Brown’s statement said.

“When the bubble burst, however, those risky mortgages defaulted in record numbers and investors were left holding worthless securities, unable to sell them,” the statement said.

“Subsequently, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage backed securities, a tacit acknowledgment of their failure to adequately assess the risks of the debt they rated.”

Brown said it was unclear how long the probe would take and what remedies and remuneration it would seek if California sued the agencies.

“This is real stuff here, and yet for the last year and a half, action has not been taken,” he said.

Federal Securities and Exchange Commission Chair Mary Schapiro on Thursday in prepared remarks said the agency was considering a series of proposals to bolster regulation of the agencies, including ones to shed light on ‘rating shopping’ and conflicts of interest by the companies, which are paid by the issuers they rate.

Brown’s probe was applauded in California State Treasurer Bill Lockyer’s office, which has been a harsh critic of credit rating agencies and has been pressing them to grade corporate debt and less risky municipal debt by the same standards.

“The state of California along with other municipal issuers are all too familiar with wildly inaccurate ratings from the agencies,” Lockyer spokesman Tom Dresslar said. “The ratings do not come close to reflecting the risk of default, which in our case is nil.”

“It’s clear that the rating agencies played a significant role in the downfall of the U.S. economy,” Dresslar said.

(Additional reporting by Jim Christie in San Francisco, Lisa Lambert in Washington and Karen Brettell in New York)

Editing by James Dalgleish and Dhara Ranasinghe

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