February 6, 2013 6:44 pm

Rating agencies must beware of the law

Free speech is no defence if standards are lowered to please issuers and gain revenues
Ingram Pinn illustration©Ingram Pinn

It has been a vintage week for old remains. A skeleton beneath a car park was confirmed as that of Richard III and the US Department of Justice exhumed Standard & Poor’s emails from nearly a decade ago. Neither was a pretty sight.

It is bizarre to be reminded of the mania inside S&P and other rating agencies in the mid-2000s as they competed to satisfy banks’ demand to rate complex securities. But that was in another country and, besides, collateralised debt obligations are dead. These days, banks are reluctant to lend to prime customers, let alone anyone else.

Since then, we have had a bevy of new laws designed to make rating agencies raise their standards and discourage investors from taking them too seriously. Do we really need to dig up an obscure statute from the 1980s savings and loans crisis to charge S&P within the statute of limitations, on a lower burden of proof?

I am tempted to say no, let’s just move on, but I think the answer is yes. S&P could be acquitted – it denies the charge and the evidence is not conclusive. But it is clear how badly conflicted rating agencies were in the housing boom, and how weak the incentive was to behave correctly. Legal jeopardy can fill the gap, albeit belatedly.

Rating agencies have faced little danger until recently, no matter how poorly they did their jobs, since they persuaded courts their ratings were nothing more than opinions, and thus protected by free-speech laws. It is no coincidence that S&P has picked as its chief US lawyer Floyd Abrams, a veteran constitutional attorney who specialises in first-amendment protection.

The argument was that, since the agencies have no contract with, or fiduciary duty to, bond investors, they can publish more or less any opinion without being liable. They might be mistaken; they might be deluded; they might call something triple A steak when it’s subprime horse. Caveat emptor.

The hole in this, of course, is that agencies are not just analysing and rating bonds for the sake of self-expression and because they enjoy it. They are being paid to do so by the issuers of bonds. In the case of mortgage securities, S&P was receiving up to $750,000 per synthetic CDO from the banks that churned them out at high speed.

Bond rating is a business and the agencies’ ratings are opinions that carry commercial weight and are cited by central banks. “Why should they get a carte blanche whereas if you go and buy a car and the dealer wrongly certifies that it is new, he is liable? Why would there be any difference?” says James Cox, a law professor at Duke University.

In fairness to S&P and the other agencies, their ratings have broadly performed well enough. Of US asset-backed securities rated triple A by S&P from 1983 to 2011, 93 per cent remained stable, and only 0.1 per cent defaulted. The rating mess in the US mortgage-backed securities market was unusual.

But that was a very big mess. Moody’s and S&P failed to anticipate the seriousness of the housing bust, or to recognise the poor quality of the subprime loans packaged into securities. Analysts who believed the models should be updated to reflect higher risks were overruled by executives who did not want to lose business from banks that shopped around for ratings.

The latest case against S&P includes many emails in which analysts complained that their work was distorted or ignored because it would curb revenues. “If we are just going to make it up to rate deals, then quants are of precious little value,” wrote one. One manager labelled his change to a model: “making sure new stuff doesn’t kill our business”.

Mr Abrams says a few snippets from 20m emails do not give a fair view of events: “No lawyer would have written some of the documents for a client, but they do not amount to fraud or misconduct. The government has marched down an unsustainable path.”

We shall see, but S&P has not improved its case by raising its standards in the wake of the crisis. It now rotates the analysts assigned to each bond issuer and has altered its risk models to make them more rigorous. If everything was done by the book, why change?

Judges are already narrowing the free-speech defence. In November
one Australian judge described S&P’s rating of two credit derivatives as “misleading and deceptive” because it hadn’t exercised proper care. In another US case, a judge ruled that ratings were not just opinions “akin to the opinion that one type of cuisine is preferable to another”.

Financial markets gain from rating agencies being able to give their informed opinions of issuers’ credit without the risk of being sued if something happens to go wrong later on. Provided they do their work honestly and diligently – to the best of their abilities – they should be shielded by the law.

But free speech is no defence for fraud and nor should it be a defence if S&P or another agency knowingly lowers its standards and risk models to please issuers and gain revenues. Investors can only expect so much from ratings but they have a right to demand integrity.

Despite their troubles, the big agencies have not lost their age-old power in the ratings market. S&P, Fitch and Moody’s, the leading rating agencies in the 2000s, retain a market share of 97 per cent. Their rivals that are paid by bond investors rather than issuers, such as Egan-Jones, remain minnows.

Issuers thus have as powerful an influence as before – an influence evident in the DoJ’s suit. Without some legal jeopardy for agencies that loosen their standards, there will always be the danger of ratings being distorted. The rater should beware.

john.gapper@ft.com

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