Justice looms large over ratings giants

'Essential cogs in the wheels of financial destruction', it appears the ramifications of the big rating agencies' role in the global financial crisis is – finally – about to him home.

If the major credit ratings agencies weren’t already paranoid about the integrity of their ratings processes, and they should be, they will be now after the US Justice Department filed a $US5 billion lawsuit against Standard & Poor’s yesterday.

Despite all the recriminations over the role the agencies played in the sub-prime credit boom and bust that led to the financial crisis the agencies had got off relatively lightly, largely because in the US their "opinions" were protected by their First Amendment constitutional rights to free speech.

To the extent that they have been subjected to some reforms, those have been very "light touch" and revolve around better disclosures rather than anything structural and the core conflicts in their "issuer pays" and profit-driven model has been left undisturbed.

The first chink in their armour appeared, here, last November when a judge in the Federal Court of Australia ruled against S&P and ABN Amro in a case brought by local councils that had invested in a particularly complex collateralised debt obligation created and marketed by ABN and rated AAA by S&P.

While S&P has said it will appeal the judgement, it is thought to be the first instance anywhere in the world that a judge in a superior court has found a ratings agency guilty of negligent conduct in assigning a rating.

The Justice Department action, based on damaging internal emails, is even more threatening. It alleges that between September 2004 and October 2007 S&P "knowingly and with intent to defraud devised, participated in and executed a scheme to defraud investors" in mortgage-related securities and falsely represented that its ratings were objective, independent and uninfluenced by any conflicts of interest.

The action seeks to circumvent the First Amendment obstacle by using a law designed to protect taxpayers from frauds against federally-insured financial institutions.

S&P, so far the only agency targeted (although Moody’s and Fitch would be nervous), has said it will vigorously defend the action and that its actions had at all times reflected its best judgements about the creditworthiness of the CDOs the Justice Department case revolves around.

It also said that it, along with everyone else, had failed to predict the speed and severity of the developing sub-prime crisis and how credit quality would ultimately be affected – although in some of the emails cited by the Justice Department there were prescient warnings of an impending disaster.

When the US Financial Inquiry Commission looked at the roles and behaviours of the agencies in the lead-up to the crisis (it concluded they were "essential cogs in the wheels of financial destruction") it heard very damaging evidence from former credit agency employees about the fixations of managements with market shares, profits and ratings volumes rather than the performance of the securities rated.

They gave evidence of changes being made to ratings methodologies and models to make them more forgiving and suggested the senior managements had been captured by their clients, the investment banks and others who paid them to rate (and sometimes help develop) structured products.

It has been evident from the far more aggressive approach the agencies have adopted in response to the tide of criticism and anger that has flowed over them post-crisis that the firms have learned some lessons from the mistakes they made pre-crisis.

The embedded conflicts in their models, however, make it difficult to be confident that they wouldn’t succumb again in future to the pressures and temptations of another boom in securities requiring their endorsement unless there were some counter-veiling pressures. The prospect of multi-billion lawsuits could provide that ongoing discipline.