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Last updated: February 5, 2013 11:32 pm
The spectre of legal action has returned to haunt the rating agencies, just as their investors believed the mistakes of the credit crisis were finally behind them.
The US Department of Justice’s lawsuit, alleging fraud at Standard & Poor’s in its rating of mortgage-related securities, not only put the threat of a $5bn-plus damages bill over S&P’s parent, McGraw-Hill, it also served as a reminder that the industry has other outstanding legal claims against it. S&P is contesting the allegations.
What it does not look like, though, is a threat to the agencies’ lucrative business model. Both McGraw-Hill and Moody’s are expected to report strong annual results in the next week, because of a boom in bond issuance and their ongoing dominance of the business of rating this debt.
To the chagrin of critics who argue the ratings business is riddled with conflicts of interest, their output remains central to the functioning of the financial system. Investors usually require two credit ratings on any complicated financial derivatives before they are willing to buy and regulators use ratings as a short-cut for calculating the capital lenders must set aside to cover likely defaults.
McGraw-Hill shares closed down nearly 11 per cent yesterday, on top of a 14 per cent fall on Monday: Moody’s, which has not attracted the same level of investigation by the DoJ, was down nearly 9 per cent, on top of an 11 per cent fall.
The suit “derails the McGraw-Hill equity story until further clarity can be obtained”, Jefferies analyst David Reynolds told clients. “The complexity of the legal processes at work make it difficult to plot likely outcomes, the uncertainty is significant here and likely to persist unless an out-of-court settlement can be reached, and we would not rule out that possibility.”
If an eventual settlement with the DoJ includes an admission of wrongdoing at S&P, or a court victory for the government undermines the “free speech” defence that has prevailed for the agencies in other cases, the latest developments could open the possibility of claims from legions of investors in toxic mortgage securities.
If not – and that was the betting of a preponderance of analysts after the publication of the DoJ’s case – this may be only the final bump on the agencies’ road back to the status quo.
Until this week, the largest outstanding legal threat to the agencies came from a case in which the Abu Dhabi Commercial Bank is suing the agencies over two structured investment vehicles created at the peak of the credit bubble, in which the investor claims it was defrauded because rating analysts did not believe the gold-plated triple A ratings they were giving to the securities.
Other court rulings had largely accepted the agencies’ argument that their ratings were opinions – in many cases, admittedly, mistaken ones – covered by the First Amendment protections for free speech.
Regulators on both sides of the Atlantic have imposed greater oversight of the agencies, aimed at monitoring how they manage the conflict of interest inherent in the fact that issuers pay for bond ratings, and can move their business to another agency if they do not like the rating offered.
In its annual report on the industry last year, the US Securities and Exchange Commission found that many agencies still breached internal processes aimed at keeping business considerations from interfering with credit research.
McGraw-Hill is selling its education business to concentrate on financial businesses including S&P. Analysts have expressed concern that the threat of a large payout to the DoJ could limit share buybacks expected from the proceeds of the $2.5bn disposal.
Larry White, a New York University economics professor who has argued for reform of the agencies and more competition for S&P and Moody’s, said the DoJ suit may throw light on a central question of the credit crisis: did S&P inflate ratings to win business from issuers?
“We know that there was shopping around by issuers that wanted better ratings. Even the rating agencies acknowledge that there was shopping around. The question is, did they give in to the blandishments, the threats and the pressure?”
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