Breakout

DOJ Sues S&P: 3 Red Flags

Breakout

The Justice Department on Monday filed civil fraud charges against McGraw-Hill Companies (MHP) and its Standard & Poor's unit, accusing the ratings agency of inflating the ratings of various mortgage based products prior to the financial crisis. It's the first major federal action taken against the ratings industry, and its nature and timing are stirring speculation, criticism and a variety of questions.

The suit is expected to be joined by a dozen states, the NY Attorney General and any other body looking to break out the torches and pitchforks and find the monster behind the financial crisis. In the charge, the DOJ says S&P "Knowingly and with the intent to defraud, devised and participated in and executed a scheme to defraud investors."

As word of the suit leaked out in late Monday trading, shares of S&P's parent company McGraw-Hill Companies plunged more than 13%. In a statement released Monday, S&P pointed out that it was not alone in failing to foresee the financial meltdown. The agency also claims that each of the products cited by the government had similar ratings from other agencies.

Taken as a whole, the behavior of the ratings agencies before, during, and after the crisis was reckless at the very least. Two years ago, the agencies as a body were cited in the Financial Crisis Inquiry Report as being "key enablers" in creating the crisis.

The Commission was hardly alone in its criticism. Breakout has been openly critical of the groups for years, as have other media outlets.

(Read more: Wall Street Dragged into Downgrade Witch hunt, Market Stabilization & Rage Against the Ratings Agencies, Ratings Agencies are Ruining the World)

None of the above, however, means the DOJ's civil suit isn't questionable both in timing and merit. Among the questions being asked on Wall Street are these:

Where is Moody's in all of this?

The DOJ says S&P inflated its ratings to gain market share, yet S&P's ratings were in fact in line with the industry. The exclusion of fellow major ratings agencies Moody's Corp. (MCO) and Fitch so far gives the appearance of long-rumored favoritism towards Moody's, in which Warren Buffett of investing and "Buffett Tax" fame is a major shareholder.

Is this retribution for S&P's 2011 downgrade of U.S. credit?

S&P was the only ratings agency to downgrade its rating of the U.S. in August of 2011 during the debt ceiling debate. The move incited rage in DC but may have been the one thing S&P has done right in years as it sent a proper message and didn't damage U.S. credit worthiness in the eyes of the market.

At the time, pols called the downgrade "irresponsible" and then held and investigation into S&P. It challenges credulity to think the DOJ's laser-focus on S&P and the 2011 downgrade are unrelated.

Is this intimidation ahead of the sequestration debate?

The U.S. is heading into another round of brutal budget debate that created a meaningful threat of yet another credit downgrade. In an ideal world of due process, the DOJ suit wouldn't have an impact on the chances of a reduction in the US rating. In the real world, the suit may reduce the likelihood of an agency taking a stance against the U.S.

Laws are enforced to punish wrong-doing, restore confidence in institutions and provide restitution for those harmed. This case does none of those things: S&P is the only body at risk thus far, the case actually reduces the appearance of objectivity in enforcement, and the basis of the case is a 1989 law created to protect financial institutions, not harmed individuals.

The burden of proof is on the government to prove the merit of the case. Unless and until it can do so, this looks like just another case of DC business as usual.

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