Rating Agencies Won't Be Able to Shut CalPers Up Easily

Seldom do I write a blog or post, merely because those on Seeking Alpha do such a splendid job of covering all the bases. However, the fact that CalPers has sued Moody's (MCO), Fitch, and Standard & Poor for providing perfect triple AAA credit ratings on junk, close to when it was trading as junk, ticked me off so much I felt it necessary to comment.

Remember, CalPers represents the biggest public pension fund for the public employees of California, which is effectively bankrupt and is now coining their own fiat money which equates to IOUs. If it wasn't from a big and important group representing the employees of the State with the biggest GDP which is in dire straits, this issue would go to the courts and be passed off in favor of the ratings agencies in a ruling roughly equating to "Nice try, but you're little people."

However, as is, the court system run by California employees is not liable to deny a fair hearing. This is bad for the ratings agencies. Most likely, the unseemly face of how ratings agencies get bribed to rate debt issues will be revealed yet again. But instead of it being spoken of mockingly by a few on Seeking Alpha, it will be served up to thousands of public employees that right now already feeling a bit angry at what government is not doing (even though they are in it).

It is almost a prima facie argument that the ratings agencies were either complicit or delinquent in their so called duties. Although CalPers may sue for their ratings on SIVs which lost them a cool $1 billion or so, it could likely set a precedent for many other lawsuits.

CalPers summed up their argument pretty clearly by stating the ratings agencies "made negligent misrepresentations" to the pension fund and that indicating there was almost no risk of loss, "proved to be wildly inaccurate and (risk was) unreasonably high." It is hard to disagree with them considering they are liable to loose $1 billion out of a $1.3 billion investment in AAA rated debt instruments.

It is a shame that there hasn't been any real reform in the ratings agencies yet. Even though they have been cited for conflicts of interest in the fact they are paid by issuers to rate debt instruments. Also numerous economists have gone to great lengths to show that they heavily contributed to the out of control mortgage mess by being complicit in ordaining all manner of derivatives qualified in their ability to grant junk bonds absolution making them AAA mortgage bonds.

The ratings agencies are familiar with onerous governmental lawsuits. Just last year they were under siege by states and municipalities for blatantly granting corporations with less credit worthiness a higher rating than states and municipalities were getting. Rather than admitting that they were once again overstating the credit worthiness of the corporations that paid them to float their less than sterling bonds, they rolled over and have been rating states and municipalities in higher regard. (I wonder if anyone will sue them for misrepresenting Californian bonds before they stopped paying their employees?)

Needless to say, the ratings agencies certainly deserve all the heat they will get for this lawsuit, and then some. California may not win considering the dire results it would pose to the ratings agencies, but if it results in any reform at all it will have been worth it for the other 99% of the people who got hurt due to their blatant misrepresentation and self serving assessments that left our economy in tatters.

So I am now wondering this: Since this is mainly a diatribe about conflict of interest, should California judges refuse to hear this because it is a conflict of interest since they are in CalPers? Questions, questions, questions. Certainly if the ratings agencies were a judge, they would have no problem with such conflicts of interest.

Comments

[TradingHelp...:]

I hope Calpers eat the for breakfast, lunch and dinner.

The ratings were so far from reality, is was verging on the criminal. Are this rating agencies even regulated.

I suffered from $1,000 dollar suited salesmen visiting me, trying to sell me complex ABS/MBS slices of debt promising me they were secure, investment grade, and high rated - citing S&P, Moodys ratings.

The only reason I didn't buy was I just couldn't understand how these packages of mortgages were structured and could be rated close to US government debt in terms of security.

Thank god I was "stupid".

Jul 16 05:10 AM

[Buy a clue:]

A logical dilemma indeed.

As for this statement, "Rather than admitting that they were once again overstating the credit worthiness of the corporations that paid them to float their less than sterling bonds.." are you saying that the municipalities and states were getting their ratings for free? If not, then why isn't there the same conflict of interest on muni ratings, considering those ratings were lower? Or is this issue a bit more complex than the knee-jerk issuer pays model?

Jul 16 09:36 AM

[Gregman2:]

"Since this is mainly a diatribe about conflict of interest, should California judges refuse to hear this because it is a conflict of interest since they are in CalPers?" This could be remanded to the 9th Circuit for review. It is likely a federal matter because it involves interstate commerce. There is some liability on the part of rating agencies here,
and it's really just a matter of how much of a toll CalPers will exact.

Jul 16 11:03 AM

[nelsb@centu...:]

Good article, well written.

Thanks

Jul 16 02:07 PM

[Moon Kil Woong:]

Buy a clue. You are correct. The issue is more dicey. Ratings agencies assess municipal bonds from payment by the municipality as well as the monoline insurers. Of course, the funny thing is the better the municipalities are and the worse they are rated is results in the bigger advantage monilines get insuring municipal bonds that are rated lower than AAA in almost all cases even if the municipal bond has never defaulted or is expected to within reason. By doing so monolines are insured a cut of the profit insuring them even if they otherwise wouldn't need to.

A sweet deal indeed. It gets even sweeter. The monolines, which may not have enough assets to back even a fraction of what they insure like AIG then pay to have the ratings agencies give them a AAA rating so they can keep insuring bonds that they could not cover if the economy collapses and there is even a fraction of defaults in what they insure. Thus, we have seen with the blowups in derivatives, that all the guarantees they issue are a house of cards and their bonds are becoming untradable. It is these that banks quietly try not to talk about.

Thus, the municipal bond issue where municipalities get te short end of the stick for being better off is directly related to the bonds that are too toxic to touch which are all connected to the shoddy work of ratings agencies and monoline insurers issuing CDOs and other badly crafted guarantees.

The ratings agencies are guilty of overrating and under rating bond prices for the same reason: Conflicts of interest when it comes to how they are paid. So far, although there is talk of reform nothing has been done about it (something about money again probably).

usmayors.org/usmayorne...

articles.moneycentral....

Thanks for your shrewd question buy a clue. Although this relationship was not the central topic of the article it is certainly worth a read as well.

Jul 18 05:12 AM

[ronmahabir:]

The key to this whole issue is who pays for the rating. The current system of having issuers engage and pay for the rating agency makes no sense. Until buyers of securities demand "real" ratings and pay for them, ratings won't mean much.

Ron Mahabir

Jul 21 03:52 AM

[Buy a clue:]

Wouldn't there be the same conflict of interest if the investors paid? If you buy into the general acceptance that one rating equals 25 basis points, would you simply increase the issuers' borrowing costs by that amount, without any guarantee that another RMBS fiasco doesn't repeat?

Asked another way, the Calpers suit is illuminating because it shows the incentive from the investors' side to buy AAA assets, no matter what's in the portfolio.

Maybe I'm the only one who's appalled that the largest public investor in the US bought up $1 billion of debt without conducting any due diligence. But, for whatever reason they did it, how would the rating equation change if Calpers had paid for the rating? Since they apparently had the incentive to juice their "AAA" returns, couldn't you argue that they would have been pushing for higher ratings on the RMBS as well back in 2006?


On Jul 18 05:12 AM Moon Kil Woong wrote:

> Buy a clue. You are correct. The issue is more dicey. Ratings agencies
> assess municipal bonds from payment by the municipality as well as
> the monoline insurers. Of course, the funny thing is the better the
> municipalities are and the worse they are rated is results in the
> bigger advantage monilines get insuring municipal bonds that are
> rated lower than AAA in almost all cases even if the municipal bond
> has never defaulted or is expected to within reason. By doing so
> monolines are insured a cut of the profit insuring them even if they
> otherwise wouldn't need to.
>
> A sweet deal indeed. It gets even sweeter. The monolines, which may
> not have enough assets to back even a fraction of what they insure
> like AIG then pay to have the ratings agencies give them a AAA rating
> so they can keep insuring bonds that they could not cover if the
> economy collapses and there is even a fraction of defaults in what
> they insure. Thus, we have seen with the blowups in derivatives,
> that all the guarantees they issue are a house of cards and their
> bonds are becoming untradable. It is these that banks quietly try
> not to talk about.
>
> Thus, the municipal bond issue where municipalities get te short
> end of the stick for being better off is directly related to the
> bonds that are too toxic to touch which are all connected to the
> shoddy work of ratings agencies and monoline insurers issuing CDOs
> and other badly crafted guarantees.
>
> The ratings agencies are guilty of overrating and under rating bond
> prices for the same reason: Conflicts of interest when it comes to
> how they are paid. So far, although there is talk of reform nothing
> has been done about it (something about money again probably). <br/>
>
> usmayors.org/usmayorne...
>
>
> articles.moneycentral....
>
>
> Thanks for your shrewd question buy a clue. Although this relationship
> was not the central topic of the article it is certainly worth a
> read as well.

Jul 21 08:41 AM

[W.E. Heasley:]

Good article. Great points.

Your question at the end of the article. You already know the answer. And you are correct!

Hence here is a question for you regarding the Political-Economy of your article:

Is not CalPers a mirror image of The Rating Agencies?

CalPers and the Rating Agencies do not have the same attributes and results? They look similar.

An extension to that argument is this: the pension plan is so under funded given its promises (even before 2007), and given the recent dismal investment return putting them further in the hole, they merely revert to playing the “blame game” to divert attention from CalPers real problems?

Jul 24 02:51 AM

[Moon Kil Woong:]

WE Heasley you are correct that CalPers is, like all government retirement systems underfunded, and is playing the blame game somewhat. However, they are also correct the ratings agencies were complicit in poor ratings.

Regarding ratings agencies. They have a vested interest to both overvalue all bonds and also undervalue municipal bonds below AAA or AAA equivalent because that way they need to get a monoline insurer to insure them which is yet another lucerative revenue stream for them.

I suppose having a national rating system would also prove insufficient because of the way government plays games with even standard stuff line unemplyment and other economic statistics.

The only way I can think of is some ratings agency composed of an equal weight of both buyers and sellers of bonds with no insurers involved. You would think financial institutions would do something like that. However, as we are finding out, they seem better at begging the government for help when they mess up than actually bothering to get anything right. If bonds were always correctly valued, their magin and edge might evaporate and they would have very few excuses for being wrong.

Jul 24 10:47 AM

[JeffDB:]

On Jul 21 08:41 AM Buy a clue wrote:

> Asked another way, the Calpers suit is illuminating because it shows the incentive from the investors' side to buy AAA assets, no matter what's in the portfolio.

Maybe I'm the only one who's appalled that the largest public investor in the US bought up $1 billion of debt without conducting any due diligence. >

It seems to me that it was more of an inadequate due diligence than none at all. Perhaps looking at the rating bureau's AAA rating was the extent of their due diligence.

> But, for whatever reason they did it, how would the rating equation change if Calpers had paid for the rating? >

I'm not sure how they would handle the billing allocation if they got away from the current system, but I tend to doubt they would bill the investor for each individual rating. In the insurance industry, the rating agencies bill the companies that want to be rated, but also charge subscribers such as insurance agents, brokerages etc. a fee for hardcopy or online access to their ratings. The access is usually to their ratings of all the companies they have rated, and there is usually an annual subscription fee which pays for updates as well.

> Since they apparently had the incentive to juice their "AAA" returns, couldn't you argue that they would have been pushing for higher ratings on the RMBS as well back in 2006? >

I imagine they wouldn't be pushing as hard, either directly or in some implied fashion. I'm sure they would prefer the higher rankings, but would also be a lot more inclined to want to know that they were pretty accurate. At least that would be my mindset if I were a purchaser, even if it were in a fiduciary capacity for someone else.

Jul 24 02:38 PM