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

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'

Start your day with The Independent, sign up for daily news emails
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Retirement Coordinator - Financial Services

Negotiable: Recruitment Genius: To provide a prompt, friendly and efficient se...

Recruitment Genius: Annuities / Pensions Administrator

Negotiable: Recruitment Genius: You will be the first point of contact for all...

Ashdown Group: HR, Payroll & Benefits Officer - Altrincham - up to £24,000.

£18000 - £24000 per annum + benefits: Ashdown Group: HR, Payroll & Benefits Of...

Ashdown Group: Learning and Development Programme Manager

£35000 - £38000 per annum + benefits : Ashdown Group: A highly successful, int...

Day In a Page

The saffron censorship that governs India: Why national pride and religious sentiment trump freedom of expression

The saffron censorship that governs India

Zareer Masani reveals why national pride and religious sentiment trump freedom of expression
Prince Charles' 'black spider' letters to be published 'within weeks'

Prince Charles' 'black spider' letters to be published 'within weeks'

Supreme Court rules Dominic Grieve's ministerial veto was invalid
Distressed Zayn Malik fans are cutting themselves - how did fandom get so dark?

How did fandom get so dark?

Grief over Zayn Malik's exit from One Direction seemed amusing until stories of mass 'cutting' emerged. Experts tell Gillian Orr the distress is real, and the girls need support
The galaxy collisions that shed light on unseen parallel Universe

The cosmic collisions that have shed light on unseen parallel Universe

Dark matter study gives scientists insight into mystery of space
The Swedes are adding a gender-neutral pronoun to their dictionary

Swedes introduce gender-neutral pronoun

Why, asks Simon Usborne, must English still struggle awkwardly with the likes of 's/he' and 'they'?
Disney's mega money-making formula: 'Human' remakes of cartoon classics are part of a lucrative, long-term creative plan

Disney's mega money-making formula

'Human' remakes of cartoon classics are part of a lucrative, long-term creative plan
Lobster has gone mainstream with supermarket bargains for £10 or less - but is it any good?

Lobster has gone mainstream

Anthea Gerrie, raised on meaty specimens from the waters around Maine, reveals how to cook up an affordable feast
Easter 2015: 14 best decorations

14 best Easter decorations

Get into the Easter spirit with our pick of accessories, ornaments and tableware
Paul Scholes column: Gareth Bale would be a perfect fit at Manchester United and could turn them into serious title contenders next season

Paul Scholes column

Gareth Bale would be a perfect fit at Manchester United and could turn them into serious title contenders next season
Inside the Kansas greenhouses where Monsanto is 'playing God' with the future of the planet

The future of GM

The greenhouses where Monsanto 'plays God' with the future of the planet
Britain's mild winters could be numbered: why global warming is leaving UK chillier

Britain's mild winters could be numbered

Gulf Stream is slowing down faster than ever, scientists say
Government gives £250,000 to Independent appeal

Government gives £250,000 to Independent appeal

Donation brings total raised by Homeless Veterans campaign to at least £1.25m
Oh dear, the most borrowed book at Bank of England library doesn't inspire confidence

The most borrowed book at Bank of England library? Oh dear

The book's fifth edition is used for Edexcel exams
Cowslips vs honeysuckle: The hunt for the UK’s favourite wildflower

Cowslips vs honeysuckle

It's the hunt for UK’s favourite wildflower
Child abuse scandal: Did a botched blackmail attempt by South African intelligence help Cyril Smith escape justice?

Did a botched blackmail attempt help Cyril Smith escape justice?

A fresh twist reveals the Liberal MP was targeted by the notorious South African intelligence agency Boss