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Connecticut Sues S&P and Moody's
On Wednesday, Connecticut Attorney General Richard Blumenthal filed complaints against Standard & Poor's (MHP) and Moody's Corp. (MCO) based on their rating of structured finance products, such as mortgage-backed securities. Rather than try to make a securities law-based claim, a tactic that has not so far succeeded, Blumenthal shrewdly used a state law, the Connecticut Unfair Trade Practices Act, to go after the companies for the way they (mis)represented their ratings process.
The act prohibits, among other things, false or deceptive advertising, which AG Blumenthal asserts S&P and Moody's engaged in by repeatedly claiming that their ratings were "objective, independent, and free of consideration [of revenue and potential repeat business]."
Both Companies Acknowledged "Issuer Pays" Conflict of Interest, But Claim the Conflict Was Managed
The core driver of the corrupted ratings, according to Blumenthal, is the fact that the issuer pays for the ratings.
If issuers have no market power -- by not contributing significantly to the rating agencies' revenues -- dismissing the conflict of interest inherent in the "issuer-pays" model is relatively easy. However, in the structured finance market, a small number of issuers put out almost all of the securities in a constant, lucrative stream, so that by making a select few issuers happy, the ratings agencies could rake in major profits. In that situation, the conflict appears far greater. Nonetheless, the complaint details claims by both companies that the conflict was effectively managed.
Ratings Shopping Allegedly Impacted Both Companies' Ratings
The hollowness of the companies' conflict-management claims, however, is revealed by the "ratings shopping" practice the complaint alleges was one way the agencies' ratings were corrupted.
To determine a rating, the companies look at the securities, assess their riskiness, and tell issuers that ratings of various levels will require certain "credit enhancements" to manage the risk to the level represented by the rating. Credit enhancements can be expensive to issuers, so they want the highest ratings with the least credit enhancements. In the highly concentrated, repeat-business, structured finance market, Blumenthal alleges that an issuer would get tentative ratings from Moody's, S&P and the much smaller Fitch, compare the credit enhancements each required, and threaten not to do the deal with whichever agencies required the most. In response, Blumenthal claims, the agencies would reduce or eliminate credit enhancements they believed necessary to justify the ratings they publicly issued.
S&P Allegedly Relied on Outdated Data to Preserve High Ratings
A more subtle way the S&P ratings were corrupted, alleges Blumenthal, was by its upper management's insistence on using an outdated model to assess the risk of the securities, despite having a more accurate version available.
S&P used a model called "LEVELs" to rate mortgage-backed securities. Prior to 2001, the complaint asserts, the model was updated regularly, but after 2001 upper management deliberately refused to use updated, more comprehensive versions of the model that were more relevant to the securities S&P was rating. The complaint suggests that since the old model produced the high-rating/low-credit enhancement result the issuers wanted, management continued to use it.
Moody's Allegedly Changed Its Models to Match S&P Results
On the other hand, the complaint alleges, as Moody's lost deals and revenue to S&P, Moody's set about changing its model. Not, mind you, so that the results would be more accurate and useful to investors, but so that they would match S&P's.
The Lawsuits Have the Potential to Cost the Ratings Agencies a Lot
Blumenthal's suits seek, among other remedies, the disgorgement of all the "revenues, profits and gains achieved in whole or in part through the unfair practices." Given that the structured finance revenue stream was so large and so important to these agencies that they allegedly corrupted their ratings to maintain it, such a remedy could be massive. If, as the case develops, that remedy appears likely, I imagine both agencies will settle for large sums. It'll be interesting to watch what the companies reserve for these cases over time.