Credit rating agencies became part of the scourge of the global financial crisis, being called everything from the three horsemen of the Apocalypse to "key enablers" of the financial meltdown, with taxpayers left to foot the bill.
They are about to become the target of Australian litigation funder IMF, which is set to issue proceedings in the Netherlands, Britain and New Zealand after a small but potentially profound win in the Federal Court on Monday in relation to the sale of so-called constant proportion debt obligations (CPDOs) to 12 councils.
While the case yesterday was also aimed at an investment bank and a finance company, it was the first time a credit rating agency has been pinged in the courts anywhere in the world for the role they played in rating the complex derivatives, which later became worthless.
Given more than $1 trillion was lost in the multitude of AAA toxic derivatives including collateralised debt obligations and CPDOs, there has been little fallout yet.
Yes there has been a lot of mud thrown at the ratings agencies, along with threats of global regulatory crackdowns and an investigation by the US Financial Crisis Inquiry Commission into the cause of the GFC, which concluded in August 2011 that "credit rating agencies were essential cogs in the wheel of financial destruction".
The agencies issued AAA ratings to complex derivatives worth trillions of dollars that turned out to be junk and, as Warren Buffett predicted in 2003, eventually blew up the financial system.
The credit rating agencies have been embroiled in about 40 cases in the US courts on various structured related products but most have been dismissed, withdrawn or appealed. Monday's court decision will also be appealed, according to a statement issued by Standard & Poor's in Australia.
Put simply, credit rating agencies, which rate everything from countries and states to companies and financial products, have survived virtually unscathed, with only some reputational damage, some erosion of confidence in their assumptions and some regulatory tinkering around the edges. While some quarters of the European Union have lobbied to have them banned from rating the debt of countries that have been bailed out, for the most part it is business as usual.
The Federal Court case, which awarded the 12 councils $13 million in damages, was small in the scheme of things but it could have a domino effect if time permits.
In some jurisdictions a six-year statute of limitations applies from the time a toxic derivative was bought rather than when the product blew up. The upshot is litigation covering products that were sold in 2006 will need to be filed in the next few weeks to ensure they meet the deadline.
It comes as huge US pension fund California Public Employees Retirement System (CalPERS) got the green light to sue two credit rating agencies S&P and Moody's for negligence in giving their highest ratings to three financial products in which CalPERS invested $US1.3 billion in 2006 and which later suffered huge subprime mortgage losses.
The rating agencies tried to get the case thrown out of court on the basis that they should be protected by the First Amendment as their ratings are based on independent opinions. However, in January, San Francisco judge Richard Kramer said the suit could proceed because CalPERS had produced evidence that, if proved in the court, would establish liability.
Another case relating to a class action in the Federal District Court Manhattan had a win on the First Amendment protection front. According to The New York Times, which reported on the class action against Morgan Stanley and two agencies, Judge Shira Scheindlin ruled: "The disclaimers in the Information Memoranda that 'a credit rating represents a rating agency's opinion regarding credit quality and is not a guarantee of performance or a recommendation to buy, sell or hold any securities', are unavailing and insufficient to protect the rating agencies from liability for promulgating misleading ratings."
The brutal reality is, these products in their many iterations could not have been sold if they were not constructed and flogged by huge investment banks and had the necessary imprimatur from the credit rating agencies.
Four and a half years after the GFC wreaked havoc on the financial system, most of the big players are untouched and still rolling along. There have been few court cases partly because the companies and councils that bought the products feel like idiots because they didn't understand what they were buying.
Instead they relied on the rating given to the investment by the credit rating agency. This took great trust on the part of investors and brought great wealth to the agencies. But this privileged position could never have happened without the Securities Exchange Commission, which, years ago gave the rating agencies the "full faith and credit" of the US government.
As Michael Hudson's book The Monster says about the subprime crisis, it involved a complex web of actors.
"It was, in other words, an extensive line-up of buck passers who could argue that someone else or no one at all was responsible for predatory tactics used to arrange mortgages."
Frequently Asked Questions about this Article…
What role did credit rating agencies play in the Global Financial Crisis (GFC)?
According to the article, credit rating agencies issued AAA ratings to complex derivatives—like collateralised debt obligations (CDOs) and CPDOs—that later turned out to be junk. Those ratings helped these products be sold widely and, as investigators concluded, the agencies were “essential cogs in the wheel of financial destruction” during the GFC.
What is the IMF litigation funder doing about CPDOs and rating agencies?
The article says Australian litigation funder IMF is set to launch proceedings in the Netherlands, Britain and New Zealand after a Federal Court win related to the sale of constant proportion debt obligations (CPDOs) to 12 councils. This action targets credit rating agencies, an investment bank and a finance company for their roles in selling these complex products.
What happened in the Federal Court case involving 12 councils and toxic derivatives?
The Federal Court awarded the 12 councils $13 million in damages over the sale of CPDOs. The decision was notable because it was the first time a credit rating agency had been singled out in court for its role in rating complex derivatives that later became worthless; the article notes Standard & Poor’s said the decision will be appealed.
Could these legal wins against rating agencies lead to more lawsuits or a domino effect?
The article suggests a possible domino effect: while the Federal Court award was relatively small, similar cases in other jurisdictions may follow. It also points out statute-of-limitations issues—some places measure limitation periods from the time a product was bought, so plaintiffs who bought toxic products in 2006 may need to file soon to meet deadlines.
What is the CalPERS lawsuit against S&P and Moody’s about?
CalPERS, the large US pension fund, was given the green light to sue S&P and Moody’s for negligence after they gave highest ratings to three financial products in which CalPERS invested US$1.3 billion in 2006 and later suffered heavy subprime mortgage losses. A US judge ruled the suit could proceed because CalPERS produced evidence that might establish liability.
Are credit rating agencies protected by free-speech (First Amendment) defenses in these cases?
The article reports mixed court outcomes. Rating agencies have argued their ratings are opinions protected by the First Amendment, but some judges have rejected that defense when plaintiffs produce evidence of misleading ratings. One Manhattan class action saw a First Amendment win for agencies, while a San Francisco judge allowed the CalPERS suit to proceed despite the agencies’ free‑speech argument.
What does this coverage mean for everyday investors who rely on credit ratings?
The article warns that many buyers relied heavily on ratings and later felt they didn’t understand what they were buying. It highlights that rating agencies enjoyed privileged influence—partly due to regulatory recognition—and that investors should be cautious about relying solely on a rating when deciding whether to buy complex financial products.
What were CPDOs and other ‘toxic derivatives,’ and why were they dangerous for investors?
The article describes CPDOs and other structured products (often sold by big investment banks) as complex derivatives that received AAA ratings but later became worthless. Their construction and sale depended on both the banks that packaged them and the ratings that gave them credibility, meaning investors who trusted the ratings were exposed to large, unexpected losses.
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