With the announcement this week of its massive $5 billion lawsuit against ratings agency Standard & Poor's, the Federal Government took a bold step to squelch any remaining independence of thought or action in the financial services industry. Given the circumstances and timing of the suit, can there be any doubt that S&P is paying the price for the August 2011 removal of its AAA rating on U.S. Treasury debt? In retaliation for the unpardonable sin of questioning the U.S. Treasury's credit worthiness, the Obama Administration is sending a loud and clear message to Wall Street: mess with the bull and get the horns. Shockingly, the blatant selectivity of the prosecution, however, has failed to ignite a backlash. But as the move violates both the spirit of the Constitution and the letter of the law in so many ways, I can't help but look at it as a sea change in the nature of our governance. Call it Lincoln with a heavy dose of Putin.   

Given the nature of the U.S. economy during the housing mania of the last decade, charging S&P with fraud is like handing out a speeding ticket at the Indy 500. Like nearly every other mainstream financial firm in the world at the time, S&P believed that the U.S. economy rested on a solid foundation of accumulated housing wealth. By 2006, the housing market was closing out one of its best decades in memory. Developers, speculators, financiers, real estate agents, bankers and even ordinary Americans had become charmed by the easy wealth of serial home purchases. The party had been orchestrated by a cadre of politicians and regulators who wanted to keep the party going and take credit for the good times.

To a degree that few Americans understand even to this day, it was not irresponsible lending, bad ratings, or excess greed that finally doomed the mortgage market, it was the simple fact that national home prices started falling. As long as prices stayed high, refinancing would have been open to borrowers, and defaults would have been manageable. Among the hordes of analysts, academics, and reporters who covered the market there were few if any standing who believed that national home prices could fall of a cliff. I know this to be true because I spent many years trying, unsuccessfully, to warn them.

From 2005 to 2008, I made scores of appearances on national television and at investment conferences around the country in which I stated that national home prices were set to decline by at least 30% and that the resulting mortgage defaults would devastate the financial sector and bring down the economy. I may have just as well been arguing that pink unicorns were about to resurrect the Soviet Union. At the 2006 Western Regional Mortgage Bankers conference I told attendees that many highly rated mortgage-backed securities, including some rated AAA, would become worthless. My debate opponent claimed that such predictions only come to pass if "an atomic bomb landed on either Los Angeles, Chicago, or New York!"

The idea that home prices could decline at all, let alone by 30% was considered beyond serious consideration. The models used by the banks, investors, government agencies, academics, and rating agencies predicted that national home prices would continue to rise, or at least stay stable. They were ALL wrong. Calls for even a 5% decline would have put S&P in the extreme minority. I know because I WAS that extreme minority and would have noticed any company joining me.   Absent such opinions, the analyses put out by S&P, Moody's, and Fitch were justifiable. So why pick on S&P? Perhaps because the other two agencies never downgraded U.S. government debt.

As proof of S&P's institutional culpability, the Justice Department provided a few e-mails sent by S&P analysts during the final stages of the housing bubble. The messages contain cynical awareness that the mortgage market was built on a house of cards. So what? To avoid guilt would S&P have to prove 100% agreement among all employees? The company readily admits that it reached its opinions through a consensus and that feelings within the firm varied.  Opinions are, by definition, nuanced and varied. During the years before the crash I received emails from many people who agreed with me but who said that their friends and co-workers believed that they "were nuts" for harboring such fears. I lost count of how many people told me that  I was nuts. Many of these e-mails could have come from S&P analysts.  

At most, S&P was guilty of a culture of complacency and group think. Ironically that spirit was engendered by the bizarre regulatory environment created for ratings agencies by the government itself. In 1973, in order to "protect" investors from unregulated markets, the SEC designated certain ratings firms as "Nationally Recognized Statistical Ratings Organizations." Thereafter, only bonds rated by sanctioned firms could be purchased by pension funds and federally insured banks. Before that time the ratings agencies were paid for their advice by bond investors. As the rule change limited the abilities of investors to choose who to ask, the ratings firms began charging bond issuers instead. This arrangement meant that interests of investors would be subordinated. In any event, the law may have mandated who could perform ratings, but it did not require anyone to take them seriously. Any decent portfolio manager recognized this conflict of interest and performed their own due diligence.

The problem was when it came to housing mortgage bond buyers who were just as clueless as the ratings agencies.  In fact, even those few buyers who knew the party would end badly, decided for themselves to keep dancing until the music stopped. It's completely hypocritical to sue the band after-the fact. Given that the SEC required investors to use these ratings agencies, should not the Justice Department be suing them instead?

The 2011 downgrade came as the government passed a weak and inconclusive patch to the debt ceiling crisis. Now, a year and a half later, we see that they have slithered out of that poorly constructed straight jacket. With the new debt piling up faster than ever, and the government showing itself to be blatantly incapable of making hard choices, it should be clear to anyone with a half semester of accounting that the Treasury debt should be downgraded. Yes the government has a printing press, but that only means that the value of the bonds will disappear through inflation rather than default. S&P was far too lenient. 

Smaller ratings agency Egan Jones (which never had the official sanction of S&P) issued harsher reports about government debt, and they have also been duly punished for their candor. In 2011 the other major ratings agency, Moody's, argued that the fiscal cliff deal agreed to by Congress and the President improved the country's fiscal position and forestalled any need to downgrade Treasury debt. However, since we never actually went over that conveniently erected fiscal cliff, why has Moody's not responded with a downgrade? Perhaps they want to stay out of court? 

Let's hope that it is still possible to get a fair hearing in a U.S. court of law, even when squaring off against the biggest and most powerful opponent the world has ever known. But even if S&P wins, we have all already lost. If it survives it will only do so after incurring huge legal bills and seeing its share price slashed. It's a foregone conclusion that no more downgrades will be coming.   

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

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