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.

The Justice Department sued S&P on Feb. 4, alleging the company inflated ratings on mortgage securities to win business, which helped trigger the financial crisis. S&P said in a Feb. 5 statement it will fight “vigorously” against the “meritless” claims. The government, which hasn’t sued Moody’s or Fitch, has proposed a trial start date of Feb. 17, 2015.

‘Mechanistic Reliance’

Spokesmen for the pension funds and attorneys general declined to comment on the ratings requirements as did Michael Adler, a spokesman for Moody’s. Governments should “reduce mechanistic reliance on ratings by modifying references to ratings in certain regulations,” Ed Sweeney, a spokesman for S&P, said in an e-mailed statement. Investor guidelines should allow for a “variety of credit opinions.” Daniel Noonan, a spokesman for Fitch, said in an e-mail.

S&P said in a September court filing that the U.S. brought its case in retaliation for downgrading the government’s credit rating to AA+ from AAA in August 2011. At a Feb. 5 news conference announcing the case, Associate Attorney General Tony West said there was “no connection” to the downgrade.

Regulators have used the ratings of S&P and Moody’s, both of which trace their roots to before the Federal Reserve was established in 1913, to manage risk. In 1936, the Office of the Comptroller of the Currency banned banks from holding bonds graded below investment grade, or less than BBB- by S&P and Baa3 at Moody’s. In 1975, SEC regulations designated the companies and Fitch as Nationally Recognized Statistical Rating Organizations, or NRSROs.

‘Competitive Moat’

The top three firms benefit from a “competitive moat,” in part because of the regulatory hurdles facing new companies, according to Peter Appert, an analyst at Piper Jaffray & Co. in San Francisco, who boosted earnings estimates for Moody’s and S&P last month.

Companies seeking accreditation by the SEC need to be in business for at least three consecutive years and prove that at a minimum 10 institutional investors use their product. Ten companies have obtained the NRSRO license.

“Most fund managers are unwilling to go through the hassle of trying to change the guidelines,” Rob Dobilas, who founded Realpoint LLC, the credit rating company bought by Morningstar Inc. in March 2010, said in a telephone interview. “I was shocked that investors pushed back” about implementing changes.

Sales Record

The ratings companies have profited from their quasi- regulatory roles with revenue for their grades at all-time highs as borrowers take advantage of record-low interest rates. Revenue at S&P grew to $2.28 billion in the year ended Sept. 30, up more than 20 percent from $1.89 billion a year earlier.

Moody’s Corp. is expected to raise its prices by 4 percent this year, Chief Financial Officer Linda Huber said at a September investor conference. The New York-based firm enjoys “incredible” pricing power since the ratings business is a “natural duopoly,” Warren Buffett, the company’s largest shareholder with an 11.3 percent stake, told the Financial Crisis Inquiry Commission in 2010.

Shares of Moody’s have climbed 46 percent this year through yesterday to $73.33, while McGraw Hill Financial has advanced 30 percent to $71.23. The S&P 500 Index has gained 25 percent this year to 1,782. S&P’s parent rose 1.5 percent today to $72.29, an all-time high.

S&P leads with a 44.8 percent market share for ratings, Moody’s holds 38.25 percent and Fitch, jointly owned by Hearst Corp. and by Fimalac SA, is at 13.4 percent, according to the 2012 SEC report.

“Ratings are enormously important as a regulatory tool,” Patrick Bolton, a finance professor at Columbia University in New York, who has studied the firms, said in a telephone interview. “They control risk-taking and it’s a very good tool when the ratings analysis is done right.”

‘Business Interests’

States aren’t obligated to use certain firms when selling bonds and decide based on best “market execution,” according to Matt Fabian, a managing director of Concord, Massachusetts- based research firm Municipal Market Advisors. All the general obligation bonds issued by New Jersey are graded by the three biggest firms as a matter of “practice,” according to Bill Quinn, a spokesman at the state’s Department of the Treasury.

In its lawsuit, New Jersey said S&P was “acting in its own business interests” when issuing top ratings to securities that were soon cut to junk. S&P corrupted its ratings process to curry favor with the largest Wall Street banks, which paid it high fees in return, California said in its lawsuit. While S&P claimed to be a gatekeeper, it instead “acted like a toll collector,” the state said.

Ratings Pressure

Ratings companies were pressured to award top grades on debt linked to subprime mortgages, or loans to borrowers with poor or limited credit histories, to win business from Wall Street banks, according to the Financial Crisis Inquiry Commission report.

When the U.S. housing boom collapsed, the world’s largest banks reported $2.1 trillion in losses and writedowns amid the worst financial crisis since the Great Depression.

“There are still problems in the industry, and without a fix, retirees, investors, and our entire economy are still vulnerable,” Democratic Senator Al Franken of Minnesota, who has proposed creating a board that would select which companies grade structured finance securities, said in an e-mailed statement. Without changes, the U.S. could “suffer through another economic collapse.”

Richard Cantor, the chief credit officer at Moody’s, said last year in an e-mail that “we have only one objective, which is to assign ratings that are indicative of the relative risk of default and losses.” Grades should be evaluated over time with defaults, not with “short-run movements in market prices,” S&P’s Sweeney said.

The rating companies are “deeply entrenched in the market,” Gene Phillips, a director at PF2 Securities Evaluations Inc., a New York company that values structured products, said in a telephone interview. “If investors aren’t going to push back on what they’re looking for, you’re not going to get improvement in standards.”