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Bond Rating Agencies Quietly, Finally Forced Into Reform

Lower-level New York court could be changing the game

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Two years ago, it looked like bond rating agencies Fitch, Moody’s (NYSE:MCO) and Standard & Poor’s were going to be let off the hook despite playing a substantial role in the 2007/2008 subprime mortgage crisis. While clearly displeased with the entire industry at the time, the Securities and Exchange Commission didn’t proceed with any real hard-hitting reprimands aimed specifically at the rating agencies, even though these firms suggested all that packaged mortgage debt was safer than it actually was.

It also looked like the federal court system was helpless to hold the likes of Moody’s, S&P and Fitch accountable, ultimately deciding in 2011 that ratings were opinions rather than facts, and were therefore protected. Ergo, the issuers of those opinions weren’t liable.

However, last week, a twist on this fading story rightfully put the credit raters back on the hot seat — and back in the courtroom.

Lightning Strikes Twice

U.S. District Judge Shira Scheindlin — for a second time, in fact — has denied requests by the rating agencies to dismiss a suit brought against them in a New York state court; the change of venue seems to be the key. This lower-level court has had the willingness to define credit ratings not as opinions, but as “fact-based opinions.”

It’s a tiny clarification that could end up changing everything … even retroactively. If these agencies had no viable supporting facts to support their opinions, those opinions (and the loss they created) are indeed materially misleading, and subject to fraud penalties.

The ruling comes as part of a suit being brought against the three credit rating agencies by King County (Washington) and the Iowa Student Loan Liquidity Corporation, which together purchased a mere $100 million of the so-called Rhinebridge structured investment vehicle (or SIV); underwriters name and track each batch of these investment pools. The plaintiffs are arguing that all three agencies, as well as Morgan Stanley (NYSE:MS), should have known that in no way, shape or form were these CMOs worthy of the AAA rating that was awarded to this particular SIV at the time it was rated. Within weeks of its issue, the Rhinebridge SIV had been downgraded to a “junk” rating, losing the bulk of its value in the process.

Per the New York court, it’s a case that deserves a trial.

Had the Rhinebridge case been the only one to get such traction, investors might have viewed Judge Scheindlin’s ruling as a lucky break for a few investors who just happened to be in the right courtroom in front of the right judge at the right time. This isn’t the first time a case holding the rating agencies liable has gotten traction, though.

In a parallel case with a batch of SIVs called Cheyne, Abu Dhabi Commercial Bank has made the same fraud claim against the big three rating agencies, and thrown Morgan Stanley into the defendant’s pit as well. Those defendants also asked the judge — Scheindlin — to dismiss that case in 2011. She declined that request as well.

With investors/victims going 2-for-2 on the accountability front, ratings agencies — as well as underwriters — are rightfully worried this lower-court backdoor could expose them all to legal liability they had once assumed was circumvented.

Death By a Thousand Cuts

Investors likely understand that credit rating agencies, like any other corporation, are in business to make money rather than perform a public service. Likewise, it’s unlikely any investor truly feels that money can’t somehow buy an undeserved positive opinion from an agency or research firm; even with a bevy of reform efforts since 2009, it’s just an ugly reality within the financial world. What’s shocking, however, is the sheer number of pieces of damning evidence the plaintiff’s lawyers were able to gather over the course of a roughly three-year investigation.

One of those big stumbling blocks is a request made by Morgan Stanley’s Greg Drennan of IKB (the key defendant) to “lobby” Standard & Poor’s because S&P “suggested that [it] might not rate the deal!!! [at all].”

It begs the question: How does one lobby a ratings firm into rating an SIV that it simply might not want to rate?

Article printed from InvestorPlace Media,

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