According to the Wall Street Journal , the Securities and Exchange Commission has opened an explosive investigation into insider trading around Standard & Poor’s downgrade of the federal government in August. This adds a whole pile of questions to an already questionable episode.
The SEC is examining specific trades that bet against the stock market and were made right before Standard & Poor’s issued the downgrade. The market lost 634.76 points after the announcement, a 5.5 percent drop—this would have produced an enormous windfall for those traders.
Sources told the Journal that “unusually broad” subpoenas have been issued to some hedge funds, trading shops, and other Wall Street outfits asking for information about certain trades. The SEC wants to know who made the trades, who was the first to hear about the Standard & Poor’s downgrade, and whom they heard it from.
In addition, it’s possible that Standard & Poor’s itself has been subpoenaed. Any leaks would logically have come from either the company or the Treasury Department, which was alerted to the move. Sources told the Journal that, at the very least, the SEC has asked Standard & Poor’s to disclose which employees knew about the looming downgrade—and a spokesperson for Standard & Poor’s would not comment on whether they received a subpoena.
While it’s conceivable a Treasury Department official tipped off some Wall Street traders about the downgrade, Standard & Poor’s has a well-known and comfy relationship with Wall Street—which pays the company’s fees—and this might make it a more likely suspect.
The Journal notes that Standard & Poor’s met with large bond investors in the weeks leading up to the downgrade, and some of those investors are not commenting on whether they’ve received subpoenas:
The bond investors included Allianz SE’s Pacific Investment Management Co., Los Angeles-based TCW Group Inc., Legg Mason Inc.’s Western Asset Management and New York asset-management giant BlackRock Inc., according to people familiar with the matter.
It couldn’t be determined Monday if any of those firms was subpoenaed by the SEC. A spokesman for TCW Group said Monday the firm hasn’t received a subpoena. Western Asset Management hasn’t received a subpoena, wrote Stephen Walsh, the firm’s chief investment officer, in an email. A BlackRock spokesman declined to comment. A spokesman for Pacific Investment Management didn’t respond to a request for comment.
The case will be hard for the SEC to prove—it must establish a direct leak that resulted in a trade. But the probe comes at a very perilous time for Standard & Poor’s and other private rating agencies. As I noted  last week, the SEC is in the midst of drawing up new guidelines mandated by the Dodd-Frank financial reforms that could seriously curtail the power and profitability of the rating agencies.
The new rules could potentially be very tough and change the entire business model, or might end up being soft, and change very little. If Standard & Poor’s officials end up in a courtroom over one of the company’s most high-profile downgrades, further underlining a relationship with Wall Street that many regulators already find too cozy, the former becomes much more likely.