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Written by: Francisco Olivera Dubón
One of the most important words in our financial system is trust. Without trust people would not deposit money in banks, banks would not do business with each other, and nobody would lend to anybody. Investors also rely on trust.
When investors purchase a stock or bond, they trust that a company’s financial statements are not fraudulent. They trust and take into account what a company’s management says.
Many investors also trusted the credit rating agencies. If they invested in a AAA rated bond, they trusted the agencies’ belief that the particular bond would not deteriorate in value. Many funds are even restricted from investing in securities rated below a certain limit.In a perfect world, all the ratings provided by the agencies would be correct. Investors who allocated money to AAA rated bonds would not lose money and demand for risky bonds would be lower. It is impossible for the agencies to get every rating correct.
But what is one to conclude if the agencies are proven wrong in many of their reports, especially their AAA rated securities? Should investors view the agencies as fraudulent?
This is the current dilemma with the agencies. Investors have lost billions of dollars in AAA rated securities that turned out to be worthless. Should the agencies be held accountable for the losses?
Historically, the agencies have been able to hide behind the first amendment, freedom of speech. They see their ratings as opinions, thus they cannot be prosecuted for issuing a rating that turned-out to be wrong.
For example, a movie critique could not be sued for expressing a positive opinion on the worst movie of all time. An individual’s opinion is their opinion, nobody can criticize that.
But where does one draw the line? If Ben Bernanke, Chairman of the Federal Reserve, were to say, “The probability of a second financial crisis has dramatically increased”; investors would act on that.
Bernanke’s opinion comes from a position of authority and internal knowledge. He cannot risk expressing such a dire opinion on the economy unless he is right. If he were to express that opinion during a strong economy, he could cause the market to crash without reason.
The rating agencies issue an opinion, but they do so from a position of authority. As Janet Tavakoli, president of Tavakoli Structured Finance, recently wrote. “The rating agencies are quick to point out that…they merely issue ‘opinions.’ But rating agencies can demand to see evidence of appropriate due diligence from the underwriters, who are obliged to perform it. Instead, rating agencies failed to adhere to basic statistical principles.”
This means that if the agencies are unsure about one of their particular ratings, they could force a company to reveal privileged (non-public) information to them. This information would then allow them to issue a sound rating.
The US government and investors expect the rating agencies to issue accurate opinions because of their privileged position. Whatever the agencies “express”, it’s more than just an opinion. But, in the eyes of the Law, the agencies may start to look quite different.
US District Judge Shira Scheindlin has rejected the notion that the agencies can seek protection under the first amendment.
In a recent ruling, regarding a case of alleged false and misleading statements in connection to subprime notes rated by the agencies, the judge said the agencies could be persecuted “if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.”
Did the “speaker” or rating analysts believe their own ratings? An instant message conversation between two Standard & Poor’s analysts speaks for itself.
“S&P employee #1: By the way that deal is ridiculous
S&P employee #2: I know, right. That model definitely does not capture half the risk
S&P employee #1: We should not be rating it.
S&P employee #2: We rate every deal. It could be structured by cows and we would rate it.”
The agencies abused their power by performing unscrupulous ratings, while pocketing high fees. Investors trusted their knowledge and provided money to many unsound borrowers and companies. The government must realize how powerful the credit rating agencies truly are and act accordingly.
In our financial system trust isn’t the most important word, its integrity. Without integrity, there would be no basis for trust. The credit rating agencies need to find the integrity they once had.
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