Non-Reform of Rating Agencies

The New York Times has a generally solid piece. “Debt Raters Avoid Overhaul After Crisis,” by David Segal, on how pretty much nothing meaningful is being done to reform the rating agencies. That of course is particularly disturbing since there are only three agencies that count, and they do not posses anything remotely resembling the clout of the major financial firms (both their profits and the fact that they control crucial infrastructure, namely, over the counter debt and derivatives trading).

But the article also has some curious omissions and misconceptions. The most glaring is that even though it depicts the proposed reforms as woefully inadequate, it undercuts that notion by rreciting the most powerful bit of rating agency PR:

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.”

What explains the timidity of Congress’ proposals? This is not a case of lobbyists beating back ideas that might hurt their clients, say those close to the discussions. Instead, Congress is worried that bold measures may backfire. The Big Three, by allowing companies and public entities to raise money by issuing debt, are an essential engine in the country’s vast credit factory, and given the still-fragile condition of the equipment, lawmakers are reluctant to try anything but basic repairs, patches and a new alarm system.

First, this discussion promotes the misconception that ratings agencies don’t lobby. They do, but not through the usual hired guns, who work on Congressmen. The rating agencies lobby quite effectively… the regulators. And since the regulators aren’t keen (and stress the central role of ratings) that makes Congress cautious.

But more important, the article fails to draw the distinction between rating of structured credits, which is where the big fees came from and where the abuses occurred, versus rating traditional products, like corporate bonds, commercial paper, and municipal debt.

The article even more curiously mentions pending lawsuits against rating agencies while failing to note they may wind up cutting that very Gordian knot, of the structured credit versus traditional ratings:

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.

When he filed his suit, Ohio’s attorney general, Richard Cordray, said that the “rating agencies’ total disregard for the life’s work of ordinary Ohioans caused the collapse of our housing and credit markets and is at the heart of what’s wrong with Wall Street today.”

After the suit was filed, Richard Blumenthal, Connecticut’s attorney general, said he planned to join the suit and thought that a “coalition of states” would also jump on the legal bandwagon — a potentially grim development for the rating agencies, which could find themselves contending with a phalanx of state officials like the one that aimed at big tobacco in the 1990s.

The Big Three object that the legislation proposed by Congress could make them more vulnerable to legal action. But they otherwise do not sound particularly exercised about much else that is likely to become law.

It is quite peculiar that the 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. From ABS Investor Advocate:

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. Abu Dhabi Commercial Bank v. Morgan Stanley & Co. (here). 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.

In her opinion, Judge Scheindlin described the “integral role” the rating agencies played in “structuring and issuing” the SIV notes. Although she did not rule on the issue, other courts have decided that rating agencies do not act as journalists when rating transactions that they helped to structure. In re Fitch (here). And if a rating agency was not acting as a journalist, it has no defense under the First Amendment, whether its ratings were circulated to the public or not.

The ABS Investor Advocate article points out that there is a second potential front for attacking the ratings agencies, namely, their role in structuring deals that turned toxic, particularly CDOs, many of which delivered catastrophic losses.

The New York Times piece does suggest a few measures that could rein in the role of ratings agencies but are not under consideration by Congress:

There is no talk, for instance, about creating a fee-financed, independent credit rating agency, one modeled along the lines of the Public Company Accounting Oversight Board, which was established to oversee auditors after the Enron debacle — an idea floated by Christopher J. Dodd, the Senate Banking Committee chairman as recently as August. [note this article about the PCAOB today]

And some of the experts cited openly dispute the assertion, made twice on the first web page of the article, that there is no ready way to rein in the agencies:

“There are a lot of complicated issues that nobody knows how to deal with, like water shortages in different parts of the world,” says Jonathan Macey, a deputy dean at Yale Law School and a member of a bipartisan task force that has conferred with lawmakers about rating agency reform. “But this isn’t one of them. We could solve this one pretty easily with a modicum of political will. It’s just mortifying.”

Need we say more….

Originally published at Naked Capitalism and reproduced here with the author’s permission.