United States of America -v- Standard and Poors – How do you rate it?

One of the factors that made the financial crisis a disaster was the role played by the ratings agencies in rating bonds that were sold. These agencies have a powerful influence over our financial health; they rate the strength of banks, stocks, shares, investments and companies so that investors (who in most cases invest our savings and pensions either directly or indirectly) can understand what is risky and what is safe. On Monday a law suit of tremendous importance was issued in the USA. 

The more risk the higher the return an investor will accept and the less risk the lower the return. If you are managing a fund, say something that is made up of the savings of people for the pensions or the wistful savings of a vanished hand, you need to have a system for rating each potential investment. At one time the investors rated the investments themselves. At one time the Court in England laid down rules for trustee investments, requiring so much be kept in a safe investment and so much in riskier investment.

Since the financial crisis all bets are off. No one really knows what is safe and what is not. Before the financial crisis and for a few years after it investment houses looked to the rating agency for advice. They followed the old business mantra for the 1980s – no one ever got fired for buying IBM. For youngsters I should explain that IBM were for a while the brand leader in computers and if a business wanted to buy a computer IBM was very much the safe bet. If an IBM computer fouled up, the manager who bought it would not get fired – he had after all bought the best.

Well I supposed no investment manager ever got fired for following the rating of Standard & Poors. It rated amongst other financial products government bonds (including the bonds issued by HM Government) and mortgage bonds. Recently the US Justice Department has announced that it started proceedings against Standard & Poors, whom it accuses of running a scheme to defraud investors in mortgage bonds.

Standard & Poors rated collateralised debt obligations with the highest rating – AAA. That rating represented, in the view of Standard and Poors that the CDOs had an extremely strong capacity to meet its financial commitments; it was the highest rating possible. Standard & Poors had a dominant position in the rating market, and probably still has, for now.

These CDOs comprised what we now know to be junk mortgages – mortgages secured in many cases over property on which the buyer could not afford to keep up payments. In America billions of dollars were invested in CDOs, much of it by government institutions and pension funds. The Justice Department seems to claim that Standard & Poors deliberately concealed the risk by rating these CDOs too highly, to enable them to earn fees. In other words, the Justice Department say that these ratings were made in bad faith.

Standard and Poors deny the allegations and say that it will defend the lawsuit. They point out other rating agencies gave similar ratings. I suppose at worse their defence comprises an admission of incompetence or negligence. At best it argues that a rating agency is merely giving an independent judgement of risk, but the investors must rely on their own skill and judgement when they buy, and not just the ratings.

The case was filed in the Californian Court and demands a jury trial and claims fraudulent misrepresentation, commercial fraud,  wire fraud, mail fraud and financial institution fraud, claiming that the fraud started in 2004, three years before the manure hit the proverbial fan. The whole of the claim is set out at http://www.justice.gov/iso/opa/resources/849201325104924250796.PDF . It makes interesting reading to a lawyer and those concerned in managing the money of others.

If the US government wins its case (or gets a substantial settlement of damages, even without any admission of liability by Standard and Poors I expect other rating agencies to be sued, both in the USA and in Europe. These days the financial institutions have sucked up so much money out of the pockets of people that people will want, if possible, to suck some back.

In the meantime in rainy old England the Chancellor of the Exchequer is basing our economic policy on preserving the AAA rating that the UK enjoys which is assigned to it by…ratings agencies.

One Response

  1. Blogged about this myself the other day. The argument that ratings are merely part of an investor’s due diligence is perfectly viable, as is the admission of misleading through incompetence. But if there’s any suggestion of actual collusion, of wilfully turning a blind eye to impaired asset quality, then S&P will be in a whole lot of well-deserved trouble. A few years back I wouldn’t have dreamed this could be the case. But post LIBOR, all bets are off.

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