Credit Ratings Can’t Claim Free Speech in Law Giving New Risks

U.S. Senator Chris Dodd and Congressman Barney Frank
Senate Banking Committee Chairman Christopher Dodd, left, and House Financial Services Chairman Barney Frank, chat during a signing ceremony for the Dodd-Frank Wall Street Reform and Consumer Protection Act in Washington, D.C., on July 21, 2010. Photographer: Win McNamee/Pool via Bloomberg

When President Barack Obama signed the Dodd-Frank financial reform bill on July 21, he capped a year-long legislative battle to stop $1.8 trillion in global financial writedowns and losses from happening again.

The law forces derivatives trading onto exchanges or similar systems, creates a consumer-protection agency to monitor loans and lets the government unwind companies whose collapse would destabilize markets.

Obama didn’t mention one culprit in the financial debacle during remarks at the Ronald Reagan Building in Washington that day: credit ratings, Bloomberg Markets magazine reports in its January issue. Before the crisis, Moody’s Investors Service, a unit of Moody’s Corp., had given AAA ratings to 42,625 mortgage-backed securities, the same seal of approval U.S. Treasury bonds get. Of those rated in 2006, 83 percent have been downgraded, Financial Crisis Inquiry Commission Chairman Phil Angelides says.

“The ratings provided little or no value,” he says.

Now, ratings companies face their own downgrade.

Largely overshadowed in the Dodd-Frank overhaul, 18 of the 848 pages strike at defenses that have allowed Moody’s, Standard & Poor’s and Fitch Ratings to defeat every ratings lawsuit they’ve faced. The bill says ratings aren’t protected by the First Amendment as free speech or by securities laws that say opinions can’t be wrong.

‘Fundamentally Commercial’

“Activities of credit rating agencies are fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts and investment bankers,” the law says.

Dodd-Frank opens the doors to new entrants. It ends the federal requirement that banks buy securities defined as investment grade by just a handful of companies that the U.S. Securities and Exchange Commission designates as qualified for this purpose.

These 10 companies, including Fitch, Moody’s and S&P, are called Nationally Recognized Statistical Rating Organizations, or NRSROs. The law requires the SEC and other agencies to develop new credit standards in two years. It also makes ratings companies verify any outside data they use to arrive at their decisions.

“The strongest piece of Dodd-Frank is the one-two punch at ratings companies,” says Frank Partnoy, a professor at the University of San Diego School of Law and author of “The Match King: Ivar Kreuger, the Financial Genius Behind a Century of Wall Street Scandals” (PublicAffairs, 2009).

First Amendment

“The bill makes it clear the First Amendment defense isn’t going to work. It stops the government from saying investors have to use these guys even when they’re wrong.”

Fitch, Moody’s and S&P control 97 percent of U.S. ratings, which make up about half of the industry’s $6 billion in global revenue, says analyst Michael Meltz, who covers the industry for JPMorgan Chase & Co.

They won’t know whether -- or how much -- the law will loosen that grip until courts weigh in and the SEC and other agencies write rules for implementing it. After Dodd-Frank passed, 3,000 finance industry lobbyists left Capitol Hill and descended on the SEC to try to beat back the reform, Angelides says.

Yet the bill is already making the industry more cautious and in some cases spurring the companies to turn away business and raise prices.

“We expect a more rigid ratings process, tighter adherence to stated policies and potential eschewing of rating very complex structured-finance instruments,” Meltz says.

Transferring Risk

Moody’s has tried to transfer the increased cost and risk to customers.

On July 19, four days after Congress passed the law, Moody’s asked Montgomery County, Maryland, to pay $98,400 to rate a $325 million bond -- boosting the fee 61 percent from a similar deal in 2009.

County Chief Administrative Officer Tim Firestine says Moody’s wanted more money to pay another company to verify the county’s projected tax revenue, one of Dodd-Frank’s requirements. Verifiers can include accountants or finance specialists. Faced with an increased risk of lawsuits, Moody’s also asked the county for indemnification, or a promise not to sue over bad ratings.

“My reaction to third-party verification was, ‘what am I paying you for?’” Firestine says. “If they’ve got a monopoly and I indemnify them, what value does their rating have anyway?”

Scaling Back

In the end, Moody’s dropped its request for higher fees and no lawsuits. Firestine says he doesn’t have a clue why. Moody’s stopped seeking indemnification anywhere in the municipal bond market in September after some issuers complained, spokesman Michael Adler says. He declined to comment on Montgomery County’s fees.

Harold McGraw, chief executive officer of S&P parent McGraw-Hill Cos., told investors on Oct. 26 he’s raising prices to help pay for increased regulatory requirements.

Fitch, a unit of Financiere Marc de Lacharriere SA in Paris, is scaling back because some customers can’t supply the information it needs under Dodd-Frank. It stopped grading development bonds from port authorities in six Ohio cities in August.

Chris Burnham, port director in Summit County, says the small firms that operate around the ports for whom he’s guaranteeing bond payments don’t have the audited financial statements Fitch demanded. S&P rated his bonds instead, he says.

New Entrants

The National Association of Insurance Commissioners is finding alternatives to NRSROs. The association’s members regulate how much capital insurers in 50 states must hold after investing money customers pay as premiums.

The association hired BlackRock Inc., the world’s biggest money manager, in September to help set capital requirements for commercial-mortgage-backed securities. That means it’s using BlackRock’s loss projections instead of NRSRO ratings. The NAIC had already hired Pacific Investment Management Co. for residential-mortgage-backed securities in 2009. The two monitor $351.4 billion of the insurers’ assets.

“Ratings companies did not assess risk accurately in 2007,” Illinois Insurance Director Michael McRaith says. “Their opinions can no longer be our sole criterion.”

Leaping Forward

After decades of being stifled by government policies favoring NRSROs, competitors are leaping into the new landscape.

Jules Kroll, who gained fame in the 1980s by doing risk consulting for Drexel Burnham Lambert Inc.’s Michael Milken and then by probing hidden assets of Ferdinand Marcos and Saddam Hussein, started Kroll Bond Ratings Inc. in August.

“We thought ratings would be a very suitable use of our fact-finding talent,” Kroll, 69, says.

Morningstar Inc. founder Joe Mansueto, known for mutual- fund rankings, began publishing credit ratings on U.S. companies in December 2009. He expanded into mortgage-backed securities in March, paying $52 million for Realpoint LLC, a 50-person firm founded in 2001. Realpoint and Kroll have NRSRO status, so they can rate new securities. Of 11 U.S. commercial-mortgage-backed-security offerings issued during the first 10 months of 2010, Realpoint was hired on four, the same number as S&P.

“This is ground zero of the credit crunch; how do you analyze complex securities?” Mansueto, 54, says. “This is what investors want solved.”

Foosball Table

Realpoint is tiny compared with the 1,250 credit analysts at Moody’s and 1,309 at S&P. But it’s bustling. On a sun-drenched morning in August, workers crowd into cubicles in a cramped office in the Philadelphia suburb of Horsham. CEO Rob Dobilas had to move a foosball table into the lobby to free up space.

Realpoint charges 225 institutional investors for what it calls surveillance, or monthly ratings updates on every loan in every CMBS. Some big customers pay more than $100,000 a year for the service, which provides 90 percent of Realpoint’s income. The rest comes from rating new securities. Because Realpoint gets most of its money from surveillance, the firm is less susceptible to the temptation to hand out high ratings on new issues to win business, Dobilas says.

“The Realpoint model removes most of the conflict of interest,” says William McNabb, CEO of Vanguard Group, the largest U.S. mutual-fund company by assets.

‘Scale in the Business’

S&P President Deven Sharma says his company still enjoys the size and reach key to serving customers.

“There is a scale in the business,” Sharma says. “We have been investing over the last 150 years.” S&P is part of McGraw-Hill’s financial services unit, which generated 70 percent of its parent’s $1.14 billion of operating income in the first nine months of 2010.

Sitting in a conference room 37 floors above the East River in Manhattan, Sharma, 55, says S&P failed to foresee the drop of 30 percent or more in U.S. housing prices in 2007. The lapse was analytical, not ethical, he says.

“We’re very disappointed and embarrassed,” he says.

Before the financial crisis, S&P had made sure AAA-rated securities could survive a 15 percent drop in the housing market. Today, Sharma says, S&P ensures mortgage securities can withstand the Great Depression’s 45 percent plunge.

S&P, Moody’s and Fitch are all fighting how Dodd-Frank saddled them with the same liability that auditors and investment bankers face as experts. The companies could lose lawsuits when clients prove negligence or sloppy work, says Michael Perino, a securities law professor at St. John’s University in New York.

‘Arthur Andersen-Type Liability’

“This is Arthur Andersen-type liability; it can bring your company down,” says Catherine Odelbo, Morningstar’s president of equity research, referring to the accounting firm that shut down after being convicted of obstructing justice in an Enron Corp. case in 2002.

Moody’s joined S&P, Fitch and Morningstar in July in refusing to allow its ratings to be attached to registration statements for asset-backed bonds. Dodd-Frank specified this requirement for such bonds because of their central role in the financial crisis. In general, the SEC regulates the content of publicly available registration statements and the penalties for inaccurate information, so investors know what they’re buying.

With ratings companies boycotting the statements in July, the finance arm of Ford Motor Co. had to delay the sale of $1.39 billion in debt. To head off further turmoil, the SEC delayed the imposition of “expert” liability until January, and then announced an indefinite postponement.

U.S. Rep. Spencer Bachus, an Alabama Republican who’s in line to chair the House Financial Services Committee in January, said in July that expert liability would cripple the flow of credit.

Triggering Discovery

The law’s long-term implications may be determined by a provision that makes it easier for clients to sue for federal securities fraud. A key step for plaintiffs is to convince a judge that their claim is serious enough to warrant discovery, in which defendants turn over documents and testify under oath. Most defendants settle if discovery is approved, Perino says.

Under Dodd-Frank, ratings companies can be subject to discovery if plaintiffs can show with their initial pleading that the companies knowingly or recklessly failed to conduct a reasonable investigation or to verify data that customers supply. Just a threat of discovery will force caution, says Columbia University Law Professor John Coffee, who helped draft Dodd-Frank as an unpaid consultant to the Securities Law Subcommittee of the U.S. Senate.

S&P spokesman Chris Atkins says lawsuits may become more common but not easier to win. Plaintiffs still have to prove companies knowingly or recklessly published a false rating, he says.

Like a Newspaper

Even before Dodd-Frank, some judges were skeptical of ratings companies’ First Amendment claims. Judge Richard Kramer refused in May to dismiss a California Public Employees’ Retirement System lawsuit in San Francisco Superior Court. Calpers, the largest U.S. public pension fund, had sued S&P, Moody’s and Fitch in 2009 to recover $1 billion the fund lost through what it called wildly inaccurate ratings.

Floyd Abrams, a partner at Cahill Gordon & Reindel LLP in New York, argued that ratings have the same First Amendment protection as newspaper editorials. Kramer disagreed, saying companies rate structured-investment vehicles to enrich themselves, not to comment on public matters.

On Dec. 10, he was scheduled to hold a hearing on additional motions to toss out the case.

Abu Dhabi Lawsuit

Plaintiffs made similar progress in September 2009. U.S. District Judge Shira Scheindlin allowed a fraud claim against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and King County in Washington state to proceed in her New York court. Investors from Australia, Bahrain, Bermuda, the Cayman Islands, Germany and the U.S. joined the suit.

The case centers on an offering of as much as $23 billion in highly rated bonds issued by Cheyne Finance Plc, a structured-investment vehicle managed by London hedge fund Cheyne Capital Management Ltd.

Scheindlin ruled that ratings companies’ compensation may have influenced how they graded the bonds. Plaintiffs claimed the ratings companies earned more as Cheyne’s sales rose. In turn, Cheyne’s ability to sell the bonds hinged on high ratings.

Heart of the Crisis

Discovery involves millions of pages of documents -- similar to suits filed in Enron’s collapse, says Daniel Drosman, an attorney at Robbins Geller Rudman & Dowd LLP.

San Diego-based Robbins represented Enron shareholders who settled claims for $7.2 billion. Lawyers are asking S&P and Moody’s in the discovery to explain issues that go to the heart of the credit crunch: how and why they gave investment-grade ratings to bonds backed by subprime mortgages and derivatives made up of bundles of the riskiest loans.

Fallout from the credit crisis still weighs on ratings companies’ shares.

McGraw-Hill climbed from a recent low of $26.95 on June 2 to $35.91 on Dec. 7, leaving the stock down 51 percent from a record high in June 2007. Moody’s rose to $26.72 on Dec. 7 from $19.90 on June 2, 60 percent lower than in June 2007.

Berkshire Hathaway Inc. CEO Warren Buffett, Moody’s biggest investor, with a 12.1 percent stake, is pulling back. He went from 48 million shares in June 2009 to 28.4 million as of Dec.

7. Buffett told Bloomberg Television in June 2010, “what was once a bulletproof franchise may not be bulletproof.”

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