While suing Standard & Poor’s for fraud, states from New Jersey to California ironically are helping fund the world’s largest credit rater’s legal defense by requiring that their pension funds use its rankings.

New Jersey, which sued S&P and its parent McGraw Hill Financial Inc. on Oct. 9 for misleading investors about the independence of its ratings, mandates that the retirement funds of state workers buy securities graded by S&P, Moody’s Investors Service or Fitch Ratings. California, which called S&P a “toll collector” in a February lawsuit, requires investments in its Public Employees’ Retirement System to be rated by S&P and Moody’s, according to the bylaws.

Six years after the start of the worst financial crisis since the Great Depression, about $440 billion in retirement funds for workers ranging from firefighters to teachers from Iowa to Mississippi still must be invested in debt blessed by the firms even though they contributed to the turmoil by incorrectly grading mortgage bonds. Federal rules to promote competition haven’t reduced the dominance of the three firms, which provided 96 percent of all ratings in 2011, according to a U.S. Securities and Exchange Commission report in November 2012.

“The mandate is just a mistake,” Lawrence White, a professor at New York University’s Leonard N. Stern School of Business, who has testified before Congress on ratings companies, said in a telephone interview. “It generates a check-the-box-type process, which can lead to major mistakes and unfortunately that’s what happened” in the last crisis.

New Rules

Of the 19 states and the District of Columbia that have sued New York-based S&P, six require use of or have references to its grades or those of Moody’s and Fitch, including Colorado, Indiana, Iowa and Mississippi, according to their investor guidelines and annual statements. The states manage almost double the $251 billion in the world’s largest mutual fund, the Vanguard Total Stock Market Index Fund, run by Valley Forge, Pennsylvania-based Vanguard Group Inc.

Even after the Financial Crisis Inquiry Commission said in 2011 that the companies “were key enablers of the financial meltdown,” fund managers in Colorado rely on S&P and Moody’s definition of investment grade, Iowa requires ratings on its investments in derivatives and Mississippi state law mandates minimum ratings from the two firms.

Lawmakers focused on the credit raters in the 2010 Dodd- Frank Act by seeking alternatives to measuring creditworthiness, such as capital requirements for broker-dealers. States regulate the $2.52 trillion of assets in their pension plans, and they have left in place many of the bylaws mandating rankings from S&P and Moody’s.

Justice Suit

“The reason why these mandates exist in the first place is because state and local actors were piggy-backing off of federal requirements for ratings,” Jeffrey Manns, an associate professor of law at George Washington University in Washington, said in a telephone interview. “The reality is state and local government entities are much more likely to move more slowly if at all” to implement changes.