First a bit of flash-back

• An estimated USD 3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007.
• These mortgages could be bundled into MBS and CDO securities that received high ratings and therefore could be sold to global investors.
• Higher ratings were believed justified by various credit enhancements including over-collateralization (i.e., pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses.
• Without the AAA ratings , demand for these securities would have been considerably less.
• When the crisis hit, Rating Agencies lowered the credit ratings on USD 1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, a firm indicator that their initial ratings were not accurate. For example, as of July 2008, Standard & Poor’s (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated “triple-A” out of a total of 4,083 tranches originally rated “triple-A;” 466 of those downgrades of “triple-A” securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by S&P.
• This put additional pressure on financial institutions to lower the value of the MBS and similar securities in their portfolio. Since certain types of institutional investors are allowed to only carry investment-grade (e.g., “BBB” and better) assets, there was forced asset sales, which could caused further devaluation.
• Then we had the worst crisis after the Great Depression with banks writing down more than USD 500 billion in the value of their securities portfolio  (which had most of these instruments) and thereby wiping down their capital which required the sate the step in and support the banks with tax payers’ money.

Why Rating Agencies Do what they Did

The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of their total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices.

The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business.

Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards.

Media reports of interviews with rating agency senior managers indicated that the competitive pressure to rate the CDO’s favorably was strong within the firms. Internal rating agency emails from before the time the credit markets deteriorated, discovered and released publicly by U.S. congressional investigators, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce negative results. For example, one email between colleagues at Standard & Poor’s states “Rating agencies continue to create and [sic] even bigger monster–the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters”

It is very clear that conflict of interest is involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.

US Department of Justice Lawsuit against S & P

On February 5th the Department of Justice filed a complaint against Standard & Poor’s (S&P) in a Los Angeles federal court. The complaint charges that the ratings agency “limited, adjusted and delayed updates to the rating criteria and analytical models” needed to evaluate risk, and, based on information from an unnamed executive, did so deliberately to protect its business. S&P has been accused by the US justice department of defrauding investors in mortgage-related securities out of at least $5bn by issuing inflated ratings to win hundreds of millions of dollars in fees.

However, this is not the first lawsuit against rating agencies. Since the crisis, 41 legal actions targeting S&P have been dropped or dismissed. The company and other ratings agencies have prevailed by asserting their rights under the first amendment of the constitution, which states that “Congress shall make no law…abridging the freedom of speech”.

So the Department Of Justice is taking a new approach, accusing the firm of knowing misrepresentation, which is not covered by the first amendment. Similar cases have failed, but the Department Of Justice ‘s complaint is based on a law passed in 1989 in response to the savings-and-loans crisis. Called the Financial Institutions Reform, Recovery, and Enforcement Act, it has never been used in this sort of case.

S&P says it will mount a defense. It will certainly present evidence that its performance during the crisis was consistent with that of others trying to determine the validity of the troubled credits, and that it operated in good faith. As the complaint makes clear, the ratings in question were issued after intense arguments within S&P about how to evaluate complex new securities—and about how to expand the business without undermining the quality of opinions.

The firm is likely to argue that the decision-making process was inherently subjective rather than intentionally fraudulent. Implicit in this defense is the notion that the decision to invest is ultimately the responsibility of the buyer—particularly if the buyer is large, established and operating under the scrutiny of federal regulators, as was the case of many investment banks.

The outcome of this lawsuit will be keenly watched. But in the recent times, the importance of rating in investment decisions has seen a clear decline and this has not been helped by some of the actions of rating agencies themselves. One example is rating downgrade of USA by S&P which was actually followed by increased demand and tightening of spreads of US Treasury Instruments! 

 (Based on various media reports and articles)