Ooh, now things are getting interesting. The subprime meltdown is moving into the usual “pin the liability on someone” phase, which is proving to be complicated, given that many of the logical suspects, meaning the original lenders, have declared bankruptcy (and in the case of mortgage broker New Century, the IRS has first dibs, since they folded owing over $400 million in corporate and payroll taxes).
An article in today’s Financial Times cites a study that contends that ratings agencies got sufficiently involved in structured finance transactions to invalidate their First Amendment defense against investor lawsuits.
If this theory is upheld in court, it creates a boatload of problems. Ratings agencies are as integral to the financial system as accounting firms, and unlike the accounting industry, which was able to go from the Big Eight to the Big Four and still (barely) offer some customer choice, there are only 3 big ratings agencies, Moody’s, S&P, and and Fitch. Not a lot of room for bankruptcies. Plus there are so many big structured finance deals that have gone south or will down the road that all of these firms would be on the ropes if they were found to be liable.
From the Financial Times:
Credit rating agencies could be held liable for investor losses on complex securities backed by risky US subprime mortgages and other assets, according to a study.
Any such liability could dramatically change the rating business by upsetting the agencies’ traditional position that their ratings are simply opinions covered by constitutional protections for free speech.
That argument has generally proved successful for the agencies in defending lawsuits brought by investors.
But the study, released in draft form last week, contends that, in the huge and growing structured finance market, agencies have become too close to the deals they rate.
The study’s authors say rating agencies have deviated from their traditional roles as providers of opinion and instead co-operate closely with investment bankers to help them secure the desired ratings to sell deals to investors.
“Unlike the traditional ratings process, in which a company can do little to change its risk characteristics in anticipation of issuance, in structured finance, the rating agency is often an active part of structuring the deal,” wrote co-authors Josh Rosner, consultant at Graham Fisher, the investment research firm, and Joseph Mason, associate finance professor at Drexel University in Philadelphia.
The big three ratings agencies – Moody’s, Fitch and Standard & Poor’s – were quick to dismiss this on Thursday, saying their role was limited to producing a rating opinion and that their rating criteria were publicly available for investment banks to use to structure transactions.
Investors have yet to test this new line of attack in any lawsuit.
In the past, agencies have responded to investor lawsuits – including those filed after the default of Orange County in California and the collapse of Enron – with the claim that they are publishers of opinion protected by the First Amendment to the US Constitution.
But Mr Rosner and Prof Mason say rating agency co-operation with deal underwriters, who also pay for the ratings, could lead courts to consider the agencies themselves as underwriters under US securities law.