Who rates the raters? Perhaps the state of California if Calpers has anything to do with proceedings. The largest public pension scheme in the US is suing the big three credit rating agencies for awarding AAA grades to securities that suffered enormous subprime losses. Suffice to say, given the size and power of the scheme – it manages a massive $173 billion of pensions after all – when Calpers sneezes, the world pays attention.
The suit filed against Moody’s, Fitch and Standard & Poor’s at the Superior Court in San Francisco, could be a watershed moment. The raters, although bloodied and their reputation in tatters, have at least managed to prevail against similar legal challenges before. However, they may meet their match squaring up against the pension giant famous for its shareholder activism.
The Calpers lawsuit alleges that "wildly inaccurate" Triple-A ratings of structured investment vehicles (SIVs) contributed to losses of over $1 billion. Nothing particularly new here, but what’s interesting is their allegation that the rating agencies not only rated the SIVs, but also the securities that the vehicles purchased, to the extent that they provided guidance to the banks on what they needed to do to obtain the crucial AAA ratings. Here lies the rub, as Calpers’ objection goes to the heart of the debate around the shadowy relationship between the financial engineers and those who rate their products.
Conflicts of interest is a phrase never far from the table as Calpers contends the SIV rating fees, which it says range from $300,000 to $1 million per deal, were reliant upon the successful sale of SIV securities. It doesn’t take Columbo to read the subtext suggesting that there were arguably one million different reasons why the agencies would do everything in their power to ensure SIVs got top ratings. Dwight Cass of breakingviews adds an important note: "If they assisted in structuring the SIVs, that undermines the raters’ assertion that their ratings constitute opinions worthy of the same First Amendment protections afforded journalists." Fitch’s then-general counsel told lawmakers investigating the Enron debacle that a rating was ‘the world’s shortest editorial’. That pretence doesn’t hold up when you’re commenting on something you designed yourself."
The case highlights just how reliant investors are upon ratings agencies for their investment decisions, even highly sophisticated ones like Calpers. Worryingly, Calpers also claim that they didn’t receive enough information from the SIVs or the raters to adequately understand the vehicles. Well, surely if you don’t understand a product then you shouldn’t really invest in it? Caveat emptor anyone? That said, Triple-A ratings are supposed to be as safe as houses – sorry, poor choice of words given subprime.
Ultimately, the entire financial services industry must take its share of the blame for the situation we find ourselves in – from asset managers, investors, and banks right through to the risk profession itself. The ratings agencies are easy scapegoats (incredibly easy, I’ll give you that) and whilst concerns about their operation and conflicts of interest might be quite correct, it was not they alone that failed to spot the looming spectre of subprime. It’s ironic that at a time where liquidity is in such short supply (unless you’re Goldman Sachs of course), everyone has been so quick to pass the buck.