Rating Agencies May Just Get Their Due

[update below]

If you’ve read this blog for a while, you know that I pretty much place the blame on the financial crisis on the outsourcing of responsibility. The regulators thought the banks would be responsible to shareholders. That made watching the banks unnecessary. Lenders thought that since most loans were securitized and sold, that the only thing that mattered was that the paperwork looked good. Who cares if what’s on the paper was false, or that the homeowners had no prayer of paying the mortgage once the teaser rate was recast.

And as far as those who bought the securitized mortgages, how many of them bothered to look at the actual mortgages themselves when ratings agencies like S&P (MHP), Moody’s (MCO) and Fitch all blessed the bond-like investments with AAA ratings? Based on those ratings, investors believed that these bonds were as safe as Treasuries! It was the ratings that created the pool of never-ending liquidity that funded the mortgages that fueled the boom. When everyone realized that the ratings were bogus, the house of cards collapsed.

The reason I mention all of this again is because Barry Ritholz pointed to a very interesting update on the ratings agency world: litigation and liability!

I’ll just say this. To me, seeing how I’m located in what was once the burley tobacco capital of the world, the position the ratings agencies are in is a similar position to the tobacco companies' many years ago:

Back when World War II was fought, few believed that cigarettes were dangerous. Later on, when some people began to suspect that tobacco was not as safe as most believed, industry experts were trotted out to tell the world how safe cigarettes were. Heck, you even saw ads touting how doctors loved them! Eventually the world realized that cigarettes were not safe at all, and that the insiders were either wrong or had purposely misled the public.

Now take that same paragraph and replace cigarettes with AAA-mortgage derivatives, and you’ll see an nearly identical pattern:

In the early days of mortgage derivatives, few believed they were dangerous. Later on, when some began to suspect that there were unanticipated dangers, the industry went on a furious lobbying campaign to tell the world that these derivatives were safe. You even had some financial masters tell the world how much they loved CDOs and the rest of the alphabet soup products. And here we are now. The supposed masters have been proven wrong. And in some cases, people have found evidence that the inside experts purposely hid knowledge that the risk was far higher than what was being disclosed to consumers of the product.

It seems as though Calpers is going to take the same approach as smokers who bought and smoked the cigarettes, and the states who collected tax from the sale of the cigarettes. Calpers sued. In their lawsuit, the pension fund holds itself completely blameless and admits that their own analysts had no idea what they were investing in when, according to the lawsuit, they say, ”no amount of due diligence” by its own analysts could have given Calpers “actual knowledge” of how conflicts of interest at the ratings agencies affected their assessment of SIVs or how heavily exposed the securities were to subprime loans. Yet, Calpers still invested more than a billion dollars of other people’s money in this crap.

And, in what is undoubtedly the pièce de résistance of coincidence, Calpers lead attorney’s name is Tabacco!

Update:

Tracy Alloway at FT Alphaville has more on the lawsuit, including a scan from the actual complaint courtesy of Zero Hedge. Here’s the thing that stands out to me. It’s where Calpers admits they had no idea what they were investing in:

“The exact make-up of assets was treated as confidential, lest anyone, even investors, learn CUSIP level data of what was contained in the SIVx and be able to copy it.”

These fiduciaries invested more than a billion into an investment vehicle and had no idea what that investment vehicle contained? ARE YOU KIDDING ME? Talk about passing the buck.

The purveyors of these investment vehicles kept investors such as Calpers completely in the dark, so pensions and other investors had no idea of the risk or reward potential of the asset. What’s shocking is that these investors believed that lack of information made the investment even better. It wasn’t a flaw. It was a feature!

I just wonder when some pensioner decides to follow Calpers litigious lead and sue Calpers for mismanagement of his or her pension.

Comments

[nobby73:]

“The exact make-up of assets was treated as confidential, lest anyone, even investors, learn CUSIP level data of what was contained in the SIVx and be able to copy it.”

This reminds me of the classic during the South Sea Bubble in 1720 were one man raised £2,000 for "carry on an undertaking of great advantage though none shall know what it is."

Most people who have had dealings with the ratings agencies know that when it comes to structured products or complex derivatives, they don't have a clue. The methodology is basically to hope that the market develops quickly enough that they can get real time default frequency data to verify the theory.

Suing them won't achieve much as they lack the money to compensate for their role in this debacle, but there needs to be urgent reform of the ratings industry. This is a crucial aspect of the financial industry and they need to be held to higher standards. In particular, the way the ratings agencies are paid for rating bonds must stop, the moral hazard is obvious.

Jul 17 04:04 AM

[john s. gordon:]

the parallel between rating agency behavior & ponzi schemes is clear.
let;s hop calpers wins its suit.
> jack

Jul 17 09:48 AM

[Gregman2:]

Apparently all the ratings agencies cared about as well was that the paperwork looked good. There really needs to be a connection between the raters and the insurers. As it stands now, the two are divorced, and since the raters are paid by the issuers, they've had an incentive to discount risk...so that the issuers can sell. Dump the risk back on the raters. It appears this is likely to happen soon.

Jul 17 03:47 PM