proceeds of the bond issuance. As a result, he says, “focus on
this non-issue has prevented addressing the real conflict of interest
problem”, which is far more serious than regulators think. “Frequently,
rating analysts report to managers with profit-and-loss
responsibilities. If no Chinese walls exist between the analysis and
business side of agencies, the potential for undesirable influences
is real,” he says.
Finally, there is a subtle but conceptually unsettling issue
at the root of the current regulatory framework which regulators
have failed to tackle – the fact that there are just nine risk categories
(from very safe to very speculative). Regulators have not
only given the rating agencies the authority to determine to which
category a particular bond belongs by whatever method they see
fit, but also the authority to define these categories. “When one
of the agencies changes the default probability target to define
what constitutes a BBB rating, they are doing something far more
important than determining if a given bond meets a certain standard.
They are in fact changing the standard – that is, changing the
regulatory environment rather than monitoring compliance with
it,” says Cifuentes.
“This point might seem arcane, yet it is the most serious
design flaw in the current regulatory framework,” he adds. “Fresh
thinking and radical reforms are needed to revive the credit markets.
Leaving them at the mercy of the institutions that showed
so much bad judgment in what was supposed to be their core
competence seems like a terrible idea.”
Calpers suit
As a result of regulators being unable to enforce any immediate
meaningful punitive action, some of the biggest investors and borrowers
have decided to sue the rating agencies. In July the largest
pension fund in the US, the California Public Employees’ Retirement
System (Calpers), filed a suit against the three leading rating
agencies over potential losses of more than US$1bn over what it
says are “wildly inaccurate” triple A ratings. That is just one of
many. As at the beginning of August, S&P said that it was facing
about 40 separate law suits from investors and institutions.
The lawsuit, filed in a California Superior Court, relates to
US$1.3bn of notes and commercial paper that was issued by three
“Fresh thinking and radical reforms
are needed to revive the credit
markets. Leaving them at the mercy
of the institutions that showed so
much bad judgment in what was
supposed to be their core competence
seems like a terrible idea.”
89
World Finance | Nov - Dec 2009
structured investment vehicles (SIVs) called Cheyne Finance LLC,
Stanfield Victoria Funding and Sigma Finance and that the pension
fund bought in 2006. At the time, the senior debt of the SIVs
was rated triple A, which the lawsuit said amounted to “negligent
misrepresentations”. The three SIVs later collapsed and defaulted
on their payment obligations to Calpers.
All three rating agencies have denied the allegations. Calpers
is suing for damages but did not specify an amount. SIVs, by
nature, were “opaque”, the pension fund said, which meant the
rating agencies’ assessment was the only real information available
to access creditworthiness. SIVs are leveraged vehicles that
held high-yielding asset, often subprime mortgages as was the case
with the SIVs that Calpers invested in. “The credit ratings on the
SIVs ultimately proved to be wildly inaccurate and unreasonably
high,” the lawsuit said.
Calpers argues that rating agencies took an inappropriate
role in recent years by helping to structure investment vehicles like
SIVs and garnering high fees in the process. Fees for rating SIVs
totalled up to US$1m in addition to the fee for rating the underlying
assets, the suit said. “The rating agencies no longer played a
passive role but would help the arrangers structure their deals so
that they could rate them as highly as possible,” says the suit.
Lawyers are not hopeful that such suits will succeed. In the
past, most have failed because rating agencies are protected by the
first amendment right to free speech. Their ratings are an “opinion”
and therefore subject to free speech protections. Whether this
will continue to be the case is a key factor in the debate about the
future of the industry. “We are all watching the Calpers suit,” says
Donald Ross, global strategist at Boyd Watterson Asset Management.
“It may be dismissed like many other suits have been on
the basis of free speech, but it has the potential to restructure the
credit rating business model.”
This may be the best hope of holding the agencies to account.
Given that international regulators have not queried the
model under which ratings are given, and that the industry body
is averse to changing much of how agencies operate, recourse
through the courts may be the only viable option.
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