Credit rating agencies dug their own graves

Credit rating agencies, including S&P, Moody's and Fitch, may try to hide behind the First Amendment to avoid investor lawsuits over their failure to sniff out problems that culminated in the financial crisis. However, moves by the SEC and Congress may soon make this legal dodge much more difficult.

The credit rating agencies essentially take the position that they are no different than a news organization and that their ratings are reported for public consumption. Connecticut Attorney General Richard Blumenthal doesn't buy it. As he told The Wall Street Journal, "The very nature of [rating firms] so-called speech is very different from the classic First Amendment-protected expression. It's much more akin to an advertisement that misstates the price of an item on sale than a political candidate on a soapbox."

McGraw Hill (MHP), parent company of Standard & Poor's, disagrees and argues that the claims by Blumenthal violate First Amendment rights and "would result in the erosion of analytical independence." But that analytical independence is exactly what's being questioned here because of the way credit ratings agencies are paid. In fact, one court filing, by Oddo Asset Management, already questions the use of First Amendment rights when a credit rating agencies is contracted by a bank to disseminate ratings to a select group of its regular institutional investors, such as what happened with many mortgage-backed securities. Oddo told the Journal this limited dissemination is a far cry from "publishing truly independent ratings for all debt securities offered and traded publicly."

This entire scenario reminds me of the scrutiny and reform that analysts were subjected to after the Internet bubble burst. Analysts, who received compensation when their investment banking firm won the contract for selling IPOs, overrated many of the Internet babies who later imploded, even as the same analysts were writing personal emails describing the offerings as junk. We haven't seen any emails from credit-rating companies calling the mortgage-backed bonds junk. Then again, the full investigation of what happened has just begun.

In fact, SEC Chairman Mary Shapiro opened an SEC credit rating agency roundtable discussion earlier this month saying, "Rating agency performance in the area of mortgage-backed securities backed by residential sub-prime loans, and the collateralized debt obligations linked to such securities has shaken investor confidence to the core."

Since the credit rating fiasco, the SEC has taken several steps to rein in the problem:

  • The agency has sought public comment on a proposal that would force credit-rating companies to disclose the data that goes into their rankings. This would enable agencies that weren't paid to rate the bonds in question to publish their own ratings.
  • Shapiro has called for an examination of credit-rating agencies' compensation models. U.S. Senator Richard Shelby agrees that ratings companies are compromised because the same banks that sell bonds pay the credit rating agencies to grade them.
U.S. Senator Jack Reed wants to make even more drastic changes. He's drafted a bill that will expand liability for credit-rating agencies. The bill will allow investors to sue firms that don't conduct a "reasonable" examination of a bank's assurances of the debt before issuing a grade on a security. He also wants to see the compensation structure changed to create incentives for accurate ratings.

In the end, I think the credit rating agencies' move to hide behind the First Amendment will backfire. While they may win some short-term battles in court, ultimately the long-term changes by the SEC and Congress that the strategy helped provoke could change the way these firms do business forever. If the credit rating agencies really wanted First Amendment amendment protection, maybe they should have taken more seriously their responsibility to inform the public.

Lita Epstein has written more than 25 books including "Reading Financial Reports for Dummies" and "Trading for Dummies."

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