S&P Being Taken to the Woodshed

McGraw-Hill's (NYSE: MHP) plans to split itself into two separate public companies may have hit a snag. The Securities and Exchange Commission has notified the company it wants to discuss some allegedly lax vetting by its Standard & Poor's credit ratings division. The SEC wants answers about a particular collateralized debt obligation, also known as a CDO, that S&P rated during the run-up to the financial crisis.

CDOs are bundles of mortgage-backed securities that are then packaged and sold as investments. Before the financial crisis, some CDOs received ratings that were as safe as U.S. Treasuries but turned out to be made up of loans with a high likelihood of default. That has brought on general dissatisfaction with the credit ratings industry as a whole.

By sending Standard & Poor's what's known as a Wells notice, the SEC is telling the company it wants it to address the regulator's concerns about how it went about rating the CDO in question, known as "Delphinus CDO 2007-1." If the SEC isn't satisfied with S&P's answers, it may press formal charges.

Garbage in, garbage out
But S&P may only be a victim of misleading information it received from the sellers of the CDOs. For example, American International Group (NYSE: AIG) last month sued Bank of America (NYSE: BAC) to recover losses it took because, it contends, Bank of America duped the ratings agencies into giving inaccurate ratings to the CDOs it sold to AIG.

In June, JPMorgan Chase (NYSE: JPM) paid $154 million to settle a case brought by the SEC. The agency alleged that JPMorgan Chase failed to tell investors that the hedge fund that picked their CDO's underlying mortgage-backed securities also bet against the CDO.

And in July, Goldman Sachs (NYSE: GS) paid $550 million to settle the SEC's claims that it also sold CDOs to investors that were assembled by a hedge fund that then bet against the investments.

It is estimated that financial companies sustained $1.82 trillion in losses when many of the underlying mortgages that were packaged into CDOs defaulted.

Be careful whom you tick off
S&P got off on the wrong foot with the government in early August when it downgraded U.S. credit, something it had been threatening to do if Congress didn't come up with a way to bring the budget deficit down. Even though Congress did pass a settlement of sorts, S&P still went ahead with the downgrade. The stock market then began its freefall.

The present action couldn't have anything to do with that downgrade, could it? I'm just sayin'.

Anyway, it may be that for S&P to avoid SEC action, it will have to show that the CDO sellers were the cause of the inaccurate ratings by giving it misleading information in the first place. In the meantime, this certainly slows down -- or may even put on hold -- McGraw-Hill's grand plan.

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