The Credit Rating Firms Are Running Scared – It’s About Time
By Shah Gilani
Contributing Writer
Money Morning
When it comes to the U.S. credit crisis, we’ve all heard the numbers. The stock market decline wiped out $7 trillion in shareholder wealth. It forced the federal government to commit to $11.6 trillion in bailout programs and stimulus spending. And it’s led to the longest U.S. downturn since the Great Depression.
Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.
Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.
But that’s about to change.
A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.
Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:
- Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
- The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE: MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
- And Morgan Stanley (NYSE: MS).
This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”
In return for the high rating, the companies received higher-than-normal fees.
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The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.
Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.
“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.
Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.
Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.
“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.
The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.
The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.
When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.
The decision received widespread media attention. But it’s only half the story.
And the media missed the other half.
In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.
This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.
A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.
About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”
According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.
E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”
Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”
In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.
According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.
By law, certain investors must rely on the ratings of a handful of companies, known as “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.
For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.
Similarly, money-market funds can only invest in the highest NRSRO-rated securities.
Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.
It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.
In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.
The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”
News and Related Story Links:
- Money Morning Market Commentary:
Fraud and Greed of Trusted Rating Agencies Helped Spread the Credit Crisis. - The Wall Street Journal:
Judge Limits Credit Firms’ 1st-Amendment Defense. - The Wall Street Journal:
Moody’s Stays in the Eye of the Storm. - Wikinvest:
Mortgage-Backed Securities. - Investopedia:
Collateralized Mortgage Obligations. - USA Today:
Ruling: Credit-rating agencies can’t use free-speech defense. - Money Morning News:
Career Regulator Mary Schapiro – a “Strong Investor Advocate” – is Reportedly Obama’s Choice for SEC Chief. - Wikinvest:
Structured Investment Vehicle. - Wikipedia:
First Amendment.
Comment by David Ivory on 11 September 2009:
Excellent and timely reporting – considering the potential impact this topic has had virtually no international exposure at all. This commentary helps to rectify that serious omission.
Comment by Bill on 11 September 2009:
Hilarious. Ironic. Maddening.
Just one more circumstance that proves we need the government out of everything but defense.
BTW, I called the Treasury and they’d never heard of the Gold Dollars mentioned in Peter Schiff: Why this Money Should Replace the U.S. Dollar.
Comment by Busy Man Fitness on 11 September 2009:
“Let’s hope we are all wealthy and retired by the time this house of cards falters.”
What goes around comes around. The ratings agencies will never get the trust they lost back, but they should still have to cough up billions if not hundreds of billions over this.
Now, the only question is when will the SEC get taken off of their pedestal?
They are just as incompetent and need to pay the price for it as well.
Comment by Busy Man Fitness on 11 September 2009:
In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.
“We are not auditors; we are not accounting firms.”
Of coarse not…
What term would you prefer?
Comment by eiffel pane on 11 September 2009:
Same old same old. I think the article kind of missed the real question. What are we going to do without credit rating agencies? What impact will that have on the capital markets? And please do not answer that we must change the issuer paid model because the so called other agencies failed even worse. By the way, why di you not mention that the lawsuit is also against Fitch? That is a big omission because in effect the three biggest agencies would go bankrupt and what then?
Comment by John on 11 September 2009:
I don’t recall seeing the special report “How China Is Axing the U.S. Dollar…” It was mentioned for new subscribers to Money Morning.
Can you tell me where I can find it?
Thanks.
John
Comment by admin on 11 September 2009:
This is where it is located —
http://www.moneymorning.com/reports/ChinaDollarReport_MMCHI0809_Layout%2014.pdf
Sorry for any confusion.
Comment by James Yamaki on 11 September 2009:
Regarding comment 5: If the malfeant rating agencies go out of business, good, there will always be new ones to step in to take their place. This is a free enterprise system we live in and people are always looking for opportunities to get in whatever it is, rating agencies, commercial banks, etc. Windows of opportunities open only for short periods before they are closed. About time something is happening to get to the bottom of this financial mess: I hope the feds go after the wrongdoers and put them out of business. They lost our trust and JUSTICE would be served.
Comment by MahopacJack on 11 September 2009:
This is only the second article I ‘ve seen about the ratings agencies. There is no doubt in my mind that they had a major role in the outcome.
In defense of them, the major culprit in my mind has always been the US Government with its lax oversight of Government Sponsored Etntities (Fannie Mae, Freddie Mac), its political demands to lower (possibly eliminate) mortgage lending standards, its willingness to allow the Debt to Asset Ratio of Investment Banks to reach LUDICROUS levels, and its willingness to allow vested interests (lobbyists) to influence the Governments actions.
I sincerely hope some good comes of the suit but we should never attempt to blame these companies for the entire problem. It should instead be placed at the doorsteps of Congress.
Comment by william hoohuli on 12 September 2009:
Can we include the three or four credit bureau that holds every working citizen in their palm. Could these credit bureau be a missing link to the above.
Comment by Henry Mermet on 15 September 2009:
Would you ever trust a law enforcement officer if time and time again he promised you that known crooks were law-abiding citizens?
The worldwide crisis has put the spotlight on false credit ratings. In the US, Chairman Dodd and his Senate Banking, Housing and Urban Affairs Committee must be commended for tackling this major issue; naturally this starts with fixing the ratings of structured products, since they are at the root of the crisis. However, it would be a grave mistake to stop there.
Flawed ratings of structured products are just one symptom of a much deeper evil, which is endemic to the issuer/pay model, to lack of accountability and to the schizophrenic arrangement whereby ratings are empowered by quasi-force of law through their effects upon financial investments via banking, insurance and pension fund rules throughout the world on the one hand, yet remain considered as mere “editorial opinions”, thus protected by the First amendment and therefore unaccountable to anyone on the other.
Beyond the rating of structured products, this deeply flawed model also affects sovereign ratings. An ill-perceived fact is that sovereign debt and sovereign ratings are just as strategically relevant to a state as the maintenance of an army. No wonder regulators and governments are not overly keen to enhance transparency here.
Yet flawed investment grade sovereign ratings result in prejudice to hundreds of thousands of holders of defaulted bonds issued by rogue yet solvent sovereign states who are thus given access to capital markets while simultaneously evading their repayment obligations to previous lenders.
In much the same way as, and for the very same reasons that, credit rating agencies (CRAs) awarded triple A ratings to what they knew – or should have known – were toxic structured products with a view to increasing their revenue, CRAs have quietly been assigning investment grade ratings to sovereign issuers whom they know to be in a state of unresolved default on debt obligations inherited from previous governments by virtue of the successor government doctrine of settled international law, despite the fact that according to CRA-published rating methodologies and definitions such investment grade ratings are only assigned to issuers who are willing to pay and settle their repayment obligations in full and on time.
They do this by disingenuously publishing footnote disclaimers concerning debt repudiations pronounced by revolutionary regimes such as those of Cuba, the People’s Republic of China, and Russia, knowing full well that the footnotes are not empowered by the quasi force of law attached to credit ratings themselves and will therefore not be binding on institutional investors who find themselves under the obligation to allocate specific amounts of capital to securities enjoying specific investment grade ratings.
This should not be mistaken for yesterday’s old-timer battle.
While the spotlight has mostly concentrated on the flawed ratings of structured products at the root of the recent crisis very little coverage has been allocated to the crucial matter of flawed sovereign ratings – although these now carry the germs of the possible next crisis since governments worldwide have de facto become the guarantors of last resort for banking and financial institutions and also private depositors, as a result of the wrongful actions of the CRAs leading to the subprime crisis in the first place.
And now that sovereign states are about to engage in a fierce competition to tap credit markets to fund their bulging deficits, more than ever before investors are going to need to tell the difference between the good, the bad and the ugly.
How intense is the pressure for CRAs to issue flawed sovereign ratings?
Had CRAs properly rated rogue solvent issuers such as the Russian Federation or the People’s Republic of China, who actively remain in a state of unresolved default, they would have forfeited each and every dollar of rating revenue from all and any issuers public or private of those two countries, by virtue of the sovereign ceiling custom whereby no issuer of a given country can enjoy a higher rating that that of the sovereign. We are talking of a potential revenue shortfall of hundreds of millions – if not billions – of dollars over the past 15 years.
Much more profitable for CRAs to assign an investment grade rating and quietly publish disclaimers on the side, which nobody reads, saying these defaults are irrelevant old hat nobody cares about, and that China and Russia have mended their ways.
Fact is: they have not. They remain fully responsible for the settlement of their predecessor governments’ payment obligations, which they can and do avoid before the courts, not on grounds of some form of limitation or cancellation but merely on grounds of sovereign immunity. And since on the other hand they are allowed to enjoy investment grade ratings assigned by the gatekeeper whom investors thought they could entrust with the mission of flagging the rogues, why should they ever bother to pay?
All this is happening under the complacent eyes of regulators who, just as they turned a blind eye to early Madoff warnings, have also turned a blind eye to complaints and documented evidence from holders of defaulted yet investment-grade rated sovereign debtors, see the very edifying complaint to the SEC (which did not act) at the following link:
http://www.globalsecuritieswatch.org/Letter_to_SEC_Inspector_General
The problem is: how are investors to tell the difference between a bona fide sovereign who is demonstrably willing to pay debts in full and on time and a rogue state with a proven track record of taking evasive action, since CRAs rate them all investment grade regardless of who is willing to pay and who is not?
While some mostly cosmetic regulatory efforts are underway on both sides of the Atlantic to end the tortious actions of reckless CRAs and regulators the overhaul will remain a toothless tiger as long as CRAs remain immune to liability and protected by the First Amendment.
Columbia University Law School professor John C. Coffee is accurate when he testifies that the administration should adopt language from Sen. Jack Reed’s proposal that would make agencies liable for their ratings if they fail to either internally investigate the factual elements relied upon for rating a security or did not use other independent sources of verification.
However he is way short of the mark when he recommends that the liability provision could be limited to structured finance offerings which according to him “is where the real problem lies”.
Somebody needs to tell Prof. Coffee – and more importantly Chairman Dodd – about rogue sovereigns.
Any attempt at restoring confidence in credit ratings is doomed to fail if flawed ratings are only fixed piecemeal thus allowing unanswerable CRAs to persist in assigning knowingly false investment grade ratings to rogue sovereigns despite documented false public accounting and unwillingness to pay.
Sovereign ratings are not mere “editorial opinions” and everybody should realize just how much power they wield all the way up to governments, heads of state, and international treaties.
Ireland recently illustrated this when a few comments from a rating agency on the Irish sovereign rating prompted immediate and furious reactions from the heart of the Irish government. This is a fully contemporary and crucial issue.
The European Parliament recently voted an unsatisfactory Regulation for credit rating agencies. Further to the action of representatives of thousands of holders of defaulted sovereign bonds it has unenthusiastically asked the European Commission for a preliminary enquiry on the matter of misleading investment grade ratings assigned the many sovereigns who remain in a state of unresolved default: such as the Russian Federation of course, but also the People’s Republic of China, Poland, Hungary, Turkey, Greece, and others, see the press release at the following link:
http://www.archive-host.com/compteur.php?url=http://sd-1.archive-host.com/membres/up/203786733364141878/G20PREN.doc
Efforts such as these should be supported by anyone interested in restoring transparency, efficiency, confidence and finally sound performance to world financial markets and economies.
Thank you for your attention.
Henry Mermet