How Congress gave the credit-rating agencies a free pass.

We know what you’re thinking: Why isn’t anyone in jail? By the summer of last year, it was clear that the subprime housing market was a catastrophe. Junk mortgages had been offered to janitors or day-care-center operators, and financial institutions had sold the debt to funds. Much of it was garbage. But we thought otherwise—because the credit-rating agencies told us so. Time after time, Fitch, Moody’s, and S&P were asked to evaluate securitized mortgage tranches, on behalf of the very issuers who pay their fees. Time after time, they blessed them with a AAA rating.

White-collar fraud convictions are notoriously hard, as the recent Bear Stearns (BSC) acquittals showed. But why aren't the feds even trying to pursue a criminal investigation of the Big Three?

Because the federal government has almost no power to do so. The credit-rating agencies lie at the heart of our financial markets, but Congress has banned the Securities and Exchange Commission from fining or prosecuting anyone who defrauds investors. Historically, the agencies have even been protected from civil lawsuits, no matter what they do. This may change in the next few weeks, as Congress considers giving the SEC broad new powers. And recently, a federal judge broke with years of precedent and allowed an investors’ lawsuit against Moody’s to move forward. But on the whole, the agencies have been remarkably shielded from legal consequences.

Consider this: Last year, the SEC released a damning report on the agencies’ role in the subprime crash. It even had a smoking gun that revealed analysts knew some securities were junk. In an internal communication, SEC investigators discovered that, “One analyst expressed concern that her firm’s model did not capture ‘half’ of the deal’s risk, but that ‘it could be structured by cows and we would rate it.’ ” The SEC had the power to conduct this investigation thanks to the Credit Rating Agency Reform Act of 2006. But the same law denied the SEC any authority to punish the agencies for fraud. All the SEC can do is tell them not to do it again.

In fact, drafters of the 2006 law went out of their way to state that it “creates no private right of action.” In other words, you can’t even use this law to sue them. As a result, whenever anyone has filed a lawsuit against the agencies, the courts have thrown them out, citing the First Amendment. In the absence of any explicit provision exposing the Big Three to civil liability, the courts have accepted their defense that they’re just citizens of the Republic, exercising their right to free speech.

The federal government may be neutered when it comes to going after the credit-rating agencies, but the state attorneys general have been surprisingly slow to step up. More than two years have passed since the collapse of the subprime market, and rating agencies are only now beginning to feel some heat.