“Ratings agencies just abjectly failed in serving the interests of investors.”
-SEC Commissioner Kathleen Casey

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Nice takedown on the highly conflicted, over rated ratings agencies in Bloomberg yesterday:

“Investors, traders and regulators have been questioning whether credit rating companies serve a good purpose ever since Enron Corp. imploded in 2001. Until four days before the Houston-based energy company filed for what was then the largest-ever U.S. bankruptcy, its debt had investment-grade stamps of approval from S&P, Moody’s and Fitch . . .

As the U.S. and other economic powers devise ways to overhaul financial regulations, they have yet to come up with plans to address one issue at the heart of the crisis: the role of the rating firms. That’s partly because the reach of the three big credit raters extends into virtually every corner of the financial system. Everyone from banks to the agencies that regulate them is hooked on ratings.

Debt grades are baked into hundreds of rules, laws and private contracts that affect banking, insurance, mutual funds and pension funds. U.S. Securities and Exchange Commission guidelines, for example, require money market fund managers to rely on ratings in deciding what to buy with $3.9 trillion of investors’ money.

State regulators depend on credit grades to monitor the safety of $450 billion of bonds held by U.S. insurance companies. Even the plans crafted by Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy Geithner to stimulate the economy count on rating firms to determine how the money will be spent.”

There’s a ton of good stuff in the full article — go read it . . .

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Sources:
Flawed Credit Ratings Reap Profits as Regulators Fail
David Evans and Caroline Salas
Bloomberg, April 29 2009

http://www.bloomberg.com/apps/news?pid=20601109&sid=au4oIx.judz4&

Category: Bailout Nation, Legal, Markets, Regulation

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15 Responses to “Ratings Agencies Abject Failure”

  1. call me ahab says:

    Barry- are their any lawsuits against the rating agencies? I would think there would be- just haven’t heard anything about any lawsuits.

  2. Transor Z says:

    Barry, S&P (A McGraw-Hill company) already figured everything out in their March 2009 White Paper, “Toward a Global Regulatory Framework for Credit Ratings.”

    http://www2.standardandpoors.com/spf/pdf/media/GlobalRegReport.pdf

    They say up front that the credit rating agencies assumptions were incorrect, since no one foresaw the U.S. housing collapse. (They neglect to mention that they didn’t even foresee any decrease in U.S. housing prices — EVER — but that’s all good.) They cite the need for industry conflict of interest rules and transparency in disclosing the relationship between ratings agencies and issuers.

    Private industry and the free market are on it! So just chillax.

  3. randomletters says:

    What’s the fundamental difference between a ratings company, and a good investment adviser or quant firm? After all, all of them are offering predictive power and analysis.

    Answer: ratings firms get paid for being wrong in favor of the rated entity. Investment advisers and quants get paid for being right, and for being first, in favor of the folks taking the risks.

    You get what you reward…

  4. Gross Negligence is still a Tort, no?

    Transor,

    S&P’s support of “Toward a Global Regulatory Framework for Credit Ratings.” is their Get out of _________- card.

  5. snapshot says:

    On pg. 8

    S&P included a standard disclaimer with Lehman’s ratings: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

    “Grassi isn’t deterred.

    “They’re saying we know you’re going to rely on us and if you get screwed, you’re on your own because our lawyers have told us to put this paragraph in here,” he says.

    “The companies have defended their ratings from lawsuits, arguing that they were just opinions, protected by the free speech guarantees of the First Amendment to the U.S. Constitution.”

    Well…then why were they paid so well for their “opinion?” Don’t they have a responsibility over and above someone like me giving my blessing and opinion about the products?

    Sort of like the reverse of screaming “fire” in a crowded building. Those folks aren’t protected by the First Amendment. Why should the SEC-condoned agency who screams “AAA” get off under the First?

  6. Myr says:

    The system is fundamentally flawed because it’s the issuers that pay for the ratings. If we don’t change that, then we have to change the laws and rules that support the ratings companies. This isn’t hard to understand, but our government doesn’t want to deal with this absurdity and the many other fundamental flaws in the system that brought us here. This crisis will not be over until our government is forced to deal with these critical problems. Give it time…the bear isn’t done and the next wave down(which won’t come for months) will be vicious.

  7. Transor Z says:

    Mark,

    The general rule in torts is that after-the-fact remedial measures are not admissible to prove liability and also don’t work to relieve you of liability for the earlier conduct.

    “Gross” is just a variant of the regular old negligence tort that incorporates a higher degree of “wrongful” conduct. So it’s harder to prove. Often you’ll see “gross negligence” in contract liability provisions to limit one party’s liability to only the worst kinds of negligent conduct. In many cases “gross negligence” by one party will trigger a requirement to indemnify the other party.

    Bear in mind that professional malpractice is nothing more than ordinary negligence as it applies to performing the tasks of certain professions.

    @snapshot: Orange County sued McGraw-Hill under a theory of negligence and breach of contract. Ten years after the California decision, there may be a lot more ammo to support claims that ratings agencies acted with reckless disregard for the truth. Bear in mind that Orange County was suing S&P for being merely incompetent. We have the “structured by cows” in-house email and others, plus whistleblower testimony. There may be enough to get the case to trial — and as Grassi says, they sure as hell don’t want a jury to get these cases. Also, the California district court opinion is not binding on SDNY federal courts, so who knows how things will turn out…

  8. VoiceFromTheWilderness says:

    If that isn’t the pot calling the kettle black I don’t know what is. Oh, so the SEC thinks other people failed the US public do they. Well, righty-o off we go, lets go a witch hunting.

    Just one question: are people ever going to learn to see the context in which statements occur? Or will they persist indefinitely in getting all gaga whenever *anyone* says something that validates their preconcieved conclusions?

  9. RW says:

    randomletters and VoiceFromTheWilderness beat me to it so I’ll only add a question.

    What kind of working environment or mechanism(s) would the rating agencies require to accomplish what the regulators (including the SEC) and most investors (including many management firms) apparently could or would not: The detection of a risky credit produced by a firm either willing to lie about (e.g., Enron) or gloss (most CDS and SIV products) its parameters?

  10. Mannwich says:

    Anyone who bases any of their decisions on the ratings agencies at this point basically deserves what’s coming to them? How are these firms still in business? Exactly what real value to do they offer? Seriously…….

  11. kansascitypothole says:

    related reading

    “Mr. Barofsky reports that his office “has been informed by the Federal Reserve that it is considering, but has not yet adopted” a plan to replace credit ratings with actual examinations of the underlying loan portfolios. He further reports that Treasury says that “conducting due diligence with respect to the underlying collateral” will be part of its plan for investing in mortgage-backed securities. Imagine that: Trying to find out what they are buying before committing your money.”

    http://online.wsj.com/article/SB124087462292661301.html

  12. Jeff,

    see: NRSRO, these rating agencies are still, gov’t enforced/approved, “Coin of the Realm”..

    Transor,

    this: “Bear in mind that professional malpractice is nothing more than ordinary negligence as it applies to performing the tasks of certain professions.”, and the rest of your explaination, was Spot-on.

    Thank you for expounding.
    ~~~
    as an aside, these cats: http://www.egan-jones.com/ in the NRSRO-sphere, seem to be the best of an, otherwise, horrid bunch.

    and, if we were in any semblance of a Free Market, these peep: http://daily.gimmecredit.com/gcdaily/request would be as well known as S&P, aka “the Standard is to make you stupid & Poor”

  13. tamasdb says:

    The trouble is that even if the rating agency’s regulatory problem was solved (which would be a tall order in itself), there still stands the difficulty to come with any credible global model. If you take the recently released IMF forecast updates, it is striking how large the 2009 growth forecast update was compared to the one published just 6 months ago (which was incidentally well into the crisis).

    The IMF is sitting on one of the best global models of the world, and still cannot come up with anything better than a wild stab into the dark (the analysis, if you are interested, is here: http://globalstructures.blogspot.com/2009/04/imf-in-dark.html). The rating agencies cannot do else than take these meaningless forecasts. The distortions originating from their business models are almost secondary to that…

  14. DeDude says:

    Maybe they have to be required to back up their words/rating with an insurance (CDS) that must be priced according to the rating. If THEY were the ones to lose big time if they misrepresented the credit risk, then I am sure they would do a better job. The did not fail for a lack of information, they failed for a lack of correct incentives.

  15. Moss says:

    It always comes back to the same adage.. Learn how NOT to be a sucker.