PROTESTING that only fools would rely on your product to make investment decisions may seem a dangerous argument to make. Yet it is one that has served credit-ratings agencies well over the years, allowing them to sell ratings to debt issuers while abjuring legal responsibility for the quality of their work. A ruling by an Australian court this week, however, has raised questions for the industry about its immunity from prosecution.The ruling in the Federal Court of Australia on November 5th held Standard & Poor’s (S&P) jointly liable with ABN AMRO, a bank, for the losses suffered by local councils that had invested in credit derivatives that were designed to pay a high rate of interest yet were also meant to be very safe. The derivatives in question were “constant proportion debt obligations” (CPDOs). These instruments make even the most ardent fans of complex financial engineering blush: they are designed to add leverage when they take losses in order to make up the shortfall. S&P’s models, which the court said blindly adopted inputs provided by ABN AMRO, gave the notes a AAA rating, judging they had about as much chance of going bust as the American government.
S&P denies that its ratings were inappropriate, and plans to appeal. But evidence before the court suggests a world of harried analysts being outsmarted by spivvy bankers. It also indicated a disturbing lack of curiosity by S&P analysts and a desire to cover up for the firm’s failings even when they fretted about a “crisis in CPDO land” and worried that some buyers of these products were “in no hurry to stay in front of the truck”. Instead of warning investors that it had made mistakes, the court found that the firm continued to provide glowing opinions on new CPDOs coming out of the ABN AMRO factory.
There is nothing in the ruling to suggest the shoddy behaviour that took place in this instance was widespread across the firm. It would be a mistake to attribute all ratings that subsequently turn out to be wrong to negligence. Making predictions is hard, as Yogi Berra, a famously quotable baseball player, noted, especially when they are about the future.
But the Australian case does challenge a central part of the defence proffered by S&P and other ratings agencies (Moody’s and Fitch are the other two big ones) in some 40 ongoing cases worldwide alleging negligence. They argue that ratings are merely opinions and protected by constitutional safeguards on free speech, and that only imprudent investors would take decisions solely based on them.
This defence has already worked in a number of high-profile cases in America. Investment analysts and lawyers reckon that there is no sign that courts elsewhere are likely to follow the Australian ruling; it may not even survive the appeal. But the reasoning in the Australian case is persuasive. The judge argued that agencies could not wash their hands of all responsibility if investors took their ratings at face value and then lost money. “The issuer of the product is willing to pay for the rating not because it may be used by participants and others interested in financial markets for a whole range of purposes but because the rating will be highly material to the decision of potential investors to invest or not,” the judge wrote.
The tendency of investors to rely on ratings is reinforced by the privileged access that agencies have to information about issuers. The agencies’ defence that theirs is just an opinion wears thin when, having looked under the hood and kicked the tyres, they then tell investors to make up their own mind from a distance. It would help if regulators forced issuers of bonds and other rated securities to provide more public information. That would allow investors to do more of their own due diligence and enable more competition between agencies to provide the best analysis to investors rather than the best service to issuers.
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