Reuters is reporting that the ratings agencies are about to get into some serious legal problems. You see,during the bubble years, the ratings agencies gave a gold-standard AAA rating to what now seems to be dubious investment vehicles. Now, investors are angry and they are starting to sue.
Calpers, the biggest U.S. public pension fund, has sued the three largest credit rating agencies for giving perfect grades to securities that later suffered huge subprime mortgage losses.
The California Public Employees’ Retirement System said in a lawsuit filed last week in California Superior Court in San Francisco that it might lose more than $1 billion from structured investment vehicles, or SIVs, that received top grades from Moody’s Investors Service Inc, Standard & Poor’s and Fitch Inc.
SIVs are complex packages of loans and debt, including subprime mortgages and collateralized debt obligations, pooled by investment banks and which then issue debt to investors.
By giving these securities their highest ratings, the agencies "made negligent misrepresentations" to the pension fund, Calpers said. Such ratings, which typically accompany investments with almost no risk of loss, "proved to be wildly inaccurate and unreasonably high."
Calpers seeks unspecified damages.
The ratings agencies deny these claims. ""The claim is without legal or factual merit, and we will take action to have it dismissed," a McGraw-Hill spokesman said. McGraw-Hill, you will recall, is the same company that created a bit of a stir when it refused to release a book critical of the ratings agencies written by blogger Barry Ritholtz (see my February article “McGraw Hill drops book critical of its own subsidiary”). The book was picked up by another publisher and has gone on to become widely read and critically acclaimed.
It does make you wonder about the ratings agencies. Just last week I mentioned that they were up to their old ways again, rating assets from tarnished investment pools Aaa. While some find their ratings defensible, the conflicts of interest inherent in the ratings agencies’ business models has led others to call for an investigation of ratings practices. Apparently, these calls have borne fruit. The Financial Time reports:
The Securities and Exchange Commission has created a new group of examiners to oversee credit rating agencies, which came under sharp criticism for their role during the financial crisis.
The SEC has already adopted a number of measures to increase transparency at credit rating agencies, which are paid by the issuers they rate. But greater oversight is needed with officials expected to conduct both routine and special examinations of their activities, Ms Schapiro is set to tell a Congressional oversight hearing on Tuesday.
‘’I also have directed the Commission staff to explore possible new regulations in this area, including limiting the potential for rating shopping,’’ Ms Schapiro said in prepared testimony to the House Financial Services subcommittee on capital markets.
These investigations are long overdue. The conflicts between the rating agencies consulting business and ratings business are exactly the types of conflicts we saw with audit firms during the tech and telecom bubble in the 1990s. And this led to disaster at firms like Enron as the Enron auditor Arthur Andersen looked the other way.
Moreover, as it stands today, audited firms actually pay for their ratings, making the ratings agencies revenue stream dependent on the firms they audit. My hope is that conflicts like this can be stopped. So, I welcome the SEC investigation and look forward to seeing substantive changes.
Meanwhile, it may take legal action like the one being initiated by Calpers to affect real change because, to date, few substantive regulatory changes have been made despite a crisis which is more than two years old.