Last year, when the US Financial Inquiry Commission filed its final report on the global financial crisis, it described the failings of credit ratings agencies as ‘’essential cogs in the wheel of financial destruction." Today, in the Federal Court of Australia, the wheel might have turned against them a little.
In what’s been hailed as a world first, Justice Jayne Jagot ruled against Standard & Poor’s and ABN Amro in a case brought against them by 13 councils that had bought what proved to be a particularly exotic and toxic form of collateralised debt obligation created and marketed by ABN Amro and rated AAA by S&P.
Litigation financier IMF has claimed the judgment, which S&P has already said it will appeal, is the first time anywhere in the world that a judge in a superior court had found a ratings agency guilty of negligent conduct in assigning a rating and could therefore pave the way for similar cases elsewhere. Indeed IMF says it is developing similar claims against S&P and ABN Amro in Europe, where it believes they sold about $2.5 billion of the particular securities involved in the Australian case.
While the case related to a particular type of derivative (constant proportion debt obligations, or CPDOs) in concept it was similar to the trillions of dollars of CDOs rated AAA by ratings agencies that subsequently turned out to be near-worthless.
US Senate committee hearings into the role of the ratings agencies after the crisis heard evidence from former employees of the big agencies that their senior management had become fixated with profits and market shares and the volume of ratings their firms were conducting rather than the performance of the securities rated.
With the issuer-pays model the agencies use there is a fundamental conflict within the business models of for-profit entities – their incentive is to win business and market share, satisfy their immediate clients and grow the pool of rateable securities rather than the performance of the credits they have rated.
In the US before the crisis there was a massive fee pool generated by the markets for securitised sub-prime debt, which the investment bankers structured and distributed and the ratings agencies rated.
There was a significant commercial benefit for both the banks and the agencies in transforming sub-prime credits into AAA-rated paper. In some instances, according to the US inquiries, agencies actually helped design and develop structured finance products that they then rated.
In today’s judgment Justice Jagot found S&P’s rating of the CPDOs as AAA was misleading and deceptive.
The AAA rating conveyed a representation that in S&P’s opinion the capacity of the notes to meet all financial obligations was extremely strong and a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care ‘’when neither was true and S&P also knew not to be true at the time made,’’ the judge found.
ABN Amro had been knowingly concerned in S&P’s contraventions of various statutes proscribing such misleading and deceptive conduct and had itself engaged in misleading and deceptive conduct and published statements that contained material information that was false.
There have been attempts to introduce stronger regulation of the credit rating agencies post-crisis but progress has been extraordinarily slow with the US Securities and Exchange Commission finally establishing an office to oversee the agencies a few months ago.
The fact that the ratings agencies’ "opinions" have Fifth Amendment protections in the US has complicated matters and in those jurisdictions, like Australia, where legislators have increased their exposure to litigation they have responded by stopping disclosure of their ratings to retail investors to limit that liability.
The US SEC reforms are light-handed and disclosure-based, with better reporting of their internal controls, separation of their sales and marketing functions from their ratings processes, better disclosure of the basis of material changes to their methodologies and the reporting of individual ratings histories.
The agencies themselves have become more aggressive in their approach to ratings (their treatment of European sovereign debt has had the Europeans frothing and threatening their own forms of heavy-handed regulation) but the conflicts and incentives built into their models and the role the three big agencies (S&P, Moody’s and Fitch) play within the global financial system means that trusting them to voluntarily maintain the independence and integrity of their ratings processes is laden with risk.
The problem for legislators, of course, is that the agencies do play a necessary role in global markets, or at least a role that the participants in those markets regard as essential. They can’t be regulated out of existence and represent a powerful force of their own.
That’s why today’s judgment, if upheld on appeal, is potentially very significant.
If the agencies’ Fifth Amendment shield provides them with some protections against angry investors, the prospect of litigation from non-US investors might create more intimidating disciplines than legislators and regulators appear able to impose.
