Satyajit Das: Over-rated - court case will not fix core problem with ratings agencies

Midweek View: The fact that the issuer, not the investor, pays for the rating means the central conflict of interest is unresolved
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The Independent Online

Dwight Eisenhower knew that allocating blame was relatively simple. "The search for a scapegoat is the easiest of all hunting expeditions," the former president once said. The US Department of Justice (DoJ) case against the ratings agency Standard & Poor's (S&P) is a belated attempt to attribute some blame for the sub-prime lending crisis.

The claims centre on allegations that S&P's ratings of certain asset backed securities lacked objectivity, failed to follow its own guidelines, fraudulently inflated credit quality and understated risks. The DoJ alleges that conflicts of interest led S&P to favour banks in order to increase revenues and market share.

The DoJ's prospects of success are unclear. With the exception of two notable cases in Australia (both subject to appeals), the rating agencies have so far avoided liability.

They have relied on the US Constitution's First Amendment (covering the right to free speech), claiming the ratings are "opinions". They have also argued that their risk assessment errors were the same as those made by regulators, banks and other market participants.

The filing may be tactical, designed to force S&P into a settlement. The DoJ would not want to risk losing a high-profile case, while S&P would not want prolonged scrutiny and disclosure of its internal practices at a lengthy public trial. The inclusion in the DoJ's filing of salacious internal emails lends weight to the idea of the tactical manoeuvrings.

One email, from December 2006, states: "Rating agencies continue to create an even bigger monster – the CDO [collateralised debt obligation] market." Another email states: "Let's hope we are all wealthy and retired by the time this house of cards falters." A text message sent in April 2007 states: "We rate every deal. It could be structured by cows and we would rate it."

But the prize for the wittiest missive must go to an analyst in March 2007 who adapts the Talking Heads song "Burning Down the House" to the situation: "Subprime is boi-ling o-ver. Bringing down the house." S&P argues that the emails disclosed are selective and taken out of context.

Unfortunately, the DoJ court action does not address the fundamental issues about rating agencies and their role in financial markets.

The continued slavish reliance on ratings is puzzling. While individual investors and smaller institutions may be entitled to some protection, it is not clear why large, sophisticated investors and highly paid fund managers should rely primarily on external ratings for their investment decisions. Given their fiduciary responsibilities, it is unclear why they should not be held accountable for any lack of independent assessment of investments.

The methodology and meaning of ratings continues to be misunderstood. While egregious errors may have been made, a rating offers a view only of the risk of non-performance over the life of the security. Ratings are valid only at a specific point, not over the term of the security. Ratings were never intended to provide a basis for pricing risk.

Despite the much publicised problems, the central role of ratings agencies in financial markets is undiminished. Capital and reserves held by banks remain substantially based on ratings by approved agencies. The acceptability of securities as collateral and the amount of credit to be advanced are also based on ratings.

Little progress has been made in developing alternatives to the existing rating firms. S&P, Moody's and the smaller Fitch continue to dominate the market and rate more than 90 per cent of the world's bonds.

Most significantly, fundamental problems, identified in numerous reports and studies, remain largely unaddressed. The fact that the issuer of the security, rather than the investor, continues to pay for the rating means that the central conflict of interest remains unresolved. With some limitations, issuers continue to be able to choose the firm that rates their debt, allowing scope for arbitrage between models to obtain the most favourable assessment.

Several years ago, Stan Correy, an Australian journalist, expressed confusion at the role of credit rating agencies: "They have become both critic and chef in the big financial kitchens, but they say they're really journalists and take no responsibility for their advice. [They] are probably beyond the law, yet governments have said their advice is mandatory. Weird." Little, it seems, has changed.

Satyajit Das is a former banker and the author of 'Traders Guns & Money' and 'Extreme Money'