Marketplace Scratch Pad

Taking the ratings agencies to court

Scott Jagow Jul 15, 2009

This is getting good. The country’s biggest public pension fund, Calpers, is suing ratings agencies for giving perfect grades to investments that turned out to be a heaping pile of garbage. I can’t wait to see what the courts say about this one.

In 2006, Calpers (California Public Employees Retirement System) invested $1.6 billion into what are known as SIV’s (Structured Investment Vehicles). SIVs are insanely complex bundles of loans and debt sold as securities — they’re part of the toxic sludge that brought down Wall Street.

The ratings agencies, Moody’s, Fitch and S & P, have been heavily criticized for giving that stuff AAA ratings. From Reuters:

By giving these securities their highest ratings, the agencies “made negligent misrepresentations” to the pension fund, Calpers said. Such ratings, which typically accompany investments with almost no risk of loss, “proved to be wildly inaccurate and unreasonably high.”

It’s true, AAA ratings have generally been associated with low risk and low volatility, but apparently SIVs are a different beast and very vulnerable to price collapses.

As Peter Cohan at Daily Finance points out:

Calpers had no idea what was actually inside the SIVs. In fact, the vendors who sold the SIVs said that they would not reveal what was inside of them in order to protect their trade secrets. I am assuming that Calpers employs investment professionals to make investment decisions. If so, those professionals were either incredibly stupid or were simply not doing their jobs when they decided to “invest” $1.6 billion in an investment that they were prohibited from understanding by its seller.

Excellent point, but this isn’t a one-sided case. There’s a serious conflict of interest with the ratings agencies. They’ll argue against the Calpers lawsuit that they are just giving their opinion, as if they were a newspaper columnist. I’m serious — they’ll trot out the First Amendment defense.

But the rating agencies are paid by the companies that issue the securities, the SIVs in this case. And institutional investors such as Calpers usually have to meet state requirements for their investing, namely that they can only buy investments of a certain rating and/or that at least one, usually more, of the three main rating agencies gives its blessing.

Yesterday, the head of the SEC, Mary Shapiro, testified to Congress that there must be more transparency in the system, for example, with sellers that are “shopping” around for the best rating:

The proposed regulations aim to eliminate the credit-shopping issue by requiring firms that solicit reports from ratings firms like Moody’s Investor Services, Standard & Poor’s and Fitch Ratings to disclose the pre-ratings they use to determine which firm to hire to conduct the analysis.

Our Senior Business Correspondent Bob Moon is reporting the Calpers story for tonight’s Marketplace. He told me one of his sources puts it this way — the way it works now, it’s like telling somebody they must read a certain newspaper, and then they have to abide by what’s in it.

It’s really an interesting issue. You can say buyer beware, and there’s certainly an element of that here, but what if the agencies that are supposed to provide the awareness aren’t doing it?

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