Who will watch the watchers?
December 11, 2009Jon Brooks 1 Comment »
Just how did mortgage-backed investments that were rated AAA by the ratings agencies Moody’s, Standard & Poor’s, and Fitch, wind up as “toxic assets” that precipitated a financial crisis that nearly brought down the world economic system last year and fed straight into this vicious recession? After all, investors depend on the agencies to assess risk, and investments rated AAA are supposed to carry virtually none of it.
Clearly, many think, new regulatory rules are in order. From the blog of the investor web site Small Cap Visions:
Where’s the accountability?
I have been a proponent of directing responsibility in last year’s credit crisis for some time now…There has been little talk up until now of (the ratings agencies) and the role they played. Quickly, rating agencies are responsible for assigning risk default likelihood on everything from government debt to junk bonds.
Much like short-term government T-bills that receive AAA ratings (considered to be risk-free), these mortgage-backed securities were being slapped with the same grades. Basically, the agencies were proclaiming that these subprime-backed securities posed as little risk of default as debt issued by the U.S. government. A monkey could tell the difference.
While I feel it was the responsibility of investors to do their own homework and see through this deception, I also feel the rating agencies have a moral obligation to correctly rate these securities. Agencies knew full well these were not AAA material, yet most likely the pressure to generate profits for the firms led them to do so.
When the same firms issuing the securities are the ones paying you to rate them, there is a flaw in the system, as obviously a conflict of interest exists.
Until now, the rating agencies have come away clean. There is chatter sometimes but the media tends to point to the banks as the major culprit. While this is true to a point, the rating agencies have not been held accountable as of yet…
As hard-working Americans deal with the aftermath of the mortgage meltdown, the rating agencies have up until this point escaped unscarred…
This October, 2008 post by the blog Anti-Dismal discusses an article published in Reason Magazine about the role of the ratings agencies in the system’s implosion:
So how did the securities maintain their high investment grades? …once people realised that there were interconnections between housing markets nationwide, why didn’t another set of experts, the rating agencies, step in and downgrade the securities? Clearly these securities were not as safe as was being assumed.
The answer, like so much of economics, has to do with incentives.
In this case, the incentives weren’t there to obtaining unbiased estimates of security values. Instead, incentives favored “rating shopping” and so, unsurprisingly, rating shopping became the norm. The Securities and Exchange Commission’s 1994 report, Concept Release: The Nationally Recognized Statistical Ratings Organization, contained the following sentences:”A mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO.” The phrase “one of the two highest rating categories” authorized the firm holding a mortgage backed security to shop for ratings. If one rating agency failed to produce a desirable rating, the firm could look for another, more favorable rating.
So the firms could get the ratings they needed, without the buyer of the securities knowing about any other lower rating. This meant that the buyer didn’t have the ability to average out different ratings to help remove the bias caused by the rate shopping. Levy and Peart note,
As long as experts were trusted and the market didn’t know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased.
So that’s a lot of funny business that went on. This New York Times article, however, says that tough new regulation on the ratings agencies does not seem to be forthcoming.
When the financial crisis began, few players on Wall Street looked more ripe for reform than the Big Three credit rating agencies.
It wasn’t just that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, played a crucial role in the epochal housing market collapse, affixing their most laudatory grades to billions of dollars worth of bonds that went bad in the subprime crisis.
It was the near universal agreement that potential conflicts were embedded in the ratings model. For years, banks and other issuers have paid rating agencies to appraise securities — a bit like a restaurant paying a critic to review its food, and only if the verdict is highly favorable.
So as Washington rewrites the rules of Wall Street, how is the overhaul of the Big Three coming? It isn’t, finance experts say.
“What you see in these bills are Botox shots,” says Joseph A. Grundfest, a professor of securities law at Stanford Law School. “For a little while, everyone is going to be frozen into a grin, and then the shots are going to wear off.”…..
However, the article says, lawsuits by the states might substitute for new regulation as a motivating factor for reform, doing for (and to) the ratings agencies what they did for (and to) the tobacco companies in the 1990s.
While Congress may be happy with cosmetic surgery, law enforcement officials are getting more aggressive. Dozens of lawsuits have been filed against the rating agencies, including a case filed on Nov. 20 by the Ohio attorney general on behalf of public pension funds. The Ohio suit, as well as the earlier suits, seeks billions of dollars in damages from the rating agencies and accuses the firms of negligence and fraud.
Here’s the press release about the Ohio lawsuit from the state’s Attorney General:
The lawsuit alleges that the rating agencies made spectacularly misleading evaluations of mortgage-backed securities due in part to the lucrative fees they received from the same issuers they were supposed to be objectively evaluating. Public statements and testimony indicate that rating agency executives and analysts knew their ratings of mortgage-backed securities were wrong. Indeed, one rating agency analyst admitted that the market for mortgage-backed securities was “little more than a house of cards” with a much higher risk of devaluation than indicated by the purported investment-grade “AAA” rating. Another rating agency analyst said that “we rate every deal. It could be structured by cows and we would rate it.”
Raymond McDaniel, CEO and Chairman of Moody’s, described the ratings frenzy: “What happened in ’04 and ’05 … is that our competition, Fitch and S&P, went nuts. Everything was investment-grade. It really didn’t matter… No one cared because the machine just kept going.” McDaniel added that Moody’s also “[drank] the Kool-Aid.”
But a post on the blog Naked Capitalism points to a key factor in the ratings agencies’ success against such lawsuits: They claim that their ratings are “‘journalistic opinions” protected on First Amendment grounds. The companies are undefeated in mounting this defense, even beating back suits involving their role in the Enron fiasco, in which they maintained an investment grade rating on Enron bonds as late as four days before the company went bankrupt. But the post also talks about a possible chink that has opened up in the First Amendment claim:
(The Times article) neglected to mention that ratings agencies have claimed, successfully, that they are entitled to a First Amendment protection from liability because their ratings are journalistic opinions. But a recent decision set a new precedent, and if it is upheld, it will upend the ratings business. First, it opens the door to a wave of lawsuits which have the potential to bankrupt the current industry leaders (the odds are that some of the key professionals might try, with sponsorship, to set up new firms). Second is that it would considerably raise the bar for conduct for anyone bold enough to rate structured credits
This post by ABS Investor Advocate, published by a law firm that represents investors in asset-backed securities lawsuits, reports on that decision:
Federal judge Shira A. Scheindlin in New York City has rejected arguments by Moody’s and S&P that the First Amendment protects them from suit for over-rating notes issued by a SIV (Structured Investment Vehicle). Judge Scheindlin’s decision will be an influential precedent in other cases pending against rating agencies around the country.
Two purchasers of notes in Cheyne SIVs sued Morgan Stanley, The Bank of New York, Moody’s, and S&P for fraud, negligent misrepresentation, breach of contract, and various other violations of law in their sale of the Cheyne notes. The rating agencies asked Judge Scheindlin to dismiss the complaint against them because they are protected by the First Amendment and because their ratings are “opinions,” and one cannot be liable for expressing an opinion.
Judge Scheindlin rejected both arguments. She concluded that the First Amendment does not apply when ratings are “disseminated …to a select group of investors rather than to the public at large.” As to the argument that ratings are opinions, Judge Scheindlin noted that one can be liable for expressing an opinion if one “does not genuinely and reasonably believe” the opinion or “if the opinion is without basis in fact.” The complaint by the two investors alleged that the rating agencies did not genuinely or reasonably believe that the ratings they assigned the Cheyne notes were accurate.
ABS Investor Advocate likes Ohio’s chances in suing the agencies, especially in light of the aforementioned court decision rejecting the First Amendment defense:
In Ohio (as in many other states), “every person that has participated in or aided the seller in any way in making such sale or contract for sale, are jointly and severally liable to the purchaser” (emphasis added). In other words, if the rating agencies “aided the [dealers] in any way” in selling the security, the Blue Sky law will hold them liable for all untrue statements made in the offering documents, including statements made by the issuer.
This could have interesting implications for the much-discussed “First Amendment” defense. The rating agencies believe that they are members of the press, and are therefore entitled to protection under the First Amendment for the ratings they assign to securities. They also believe that their ratings are statements of “opinion” and thus cannot be untrue or misleading. But if the rating agencies could be held liable for statements made by the issuers of the securities, then both of these defenses might not apply.
This post from a blog that deals with Directors & Officers liability, however, isn’t as sanguine about the Ohio suit’s merits or its value to plaintiffs.
…the rating agencies have proven to be a popular target for investors angry about losses they sustained on mortgage-backed securities and other investments following the subprime meltdown. But as I have also previously noted, these investor actions could face significant hurdles, particularly with respect to the rating agencies’ constitutional defenses. Significant case law supports the rating agencies’ position that their ratings opinions are protected by the first amendment.
In attempting to overcome these arguments, the Ohio funds will undoubtedly seek to rely on Judge Shira Scheindlin’s September 2009 opinion in the Cheyne Financial case, in which she rejected the rating agencies’ argument that their rating opinions were entitled to immunity under the First Amendment.
But as I noted in my prior post discussing Judge Scheindlin’s opinion, the extent to which these plaintiffs will be able to rely on her opinion may be limited. First, as a district court opinion, it will be of at most persuasive but not precedential value. Moreover, Judge Scheindlin’s conclusions were made in the context of an action made under New York’s fraud laws, which may or may not be relevant to an action under Ohio’s laws.
In addition, Judge Scheindlin’s ruling in the case was limited by its own terms. In disallowing the first amendment defense, she said “where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is note afforded the same protection.” To the extent the ratings the Ohio funds’ allege to be misleading were not made to a select group of investors, as was the case with respect to the investments involved in the Cheyne Financial case, Judge Scheindlin’s ruling arguably may not be relevant….
…there is a very interesting question about whether the kinds of lawsuits (Ohio Attorney General) Cordray is busy congratulating himself for filing (at least to the extent they are filed against publicly traded companies, as opposed to the rating agencies) actually benefit the pension funds (that lost money in SIVs) over the long haul.
Whatever solutions, if any, end up being applied, it may be a long time before anyone takes a stellar rating on any investment at face value.
April 28th, 2010 at 3:42 pm
[...] the other hand, considering the role that the ratings agencies played in the sub-prime real estate implosion, someone may want to rate the [...]