Ratings Agencies Lose Free Speech Immunity

From the WSJ, an important ruling affecting the backlog of lawsuits against Moody's (MCO), S&P (MHP), and Fitch:

U.S. District Judge Shira Scheindlin ruled on Wednesday in a 68-page opinion that the ratings of certain securities -- those that were distributed to a limited number of investors -- don't deserve the same free-speech protection as more general ratings of corporate bonds that were widely disseminated.

In other words, you can see the rating of IBM in Google Finance, or other free websites. It's on IBM's investor relations page. In contrast, some special investment vehicles have a rating known to a relatively small number of investors. It's not illegal to mention the rating, but really, who cares about such parochial funds. The example given was for a $1B fund, but there are about $400B of such funds.

I am very sympathetic to the Rating Agencies because I know that in general Moody's is filled with thoughtful, sincere people, who because of their culture, have better ethics than your average investment banker. That is, very few people who work at Ratings agencies make the kind of money prominent investment bankers do, and their steady, salaried work generates more far-sighted thinking. Nonetheless, they got caught up like everyone else in assuming that in aggregate, US houses can not decline in value, an assumption that drove all the insanity.

I am not sympathetic to the 'free speech' gambit, because that seems a bit strained. As the judge noted, it's not like they wrote a newspaper article on their opinion, but rather, they were paid by a small group of people to deliver a rating delivered to a small group of investors. Potentially, there is negligence and bad faith involved. If I were the rating agencies, I would argue this was merely a good faith error, and highlight how conventional their opinions were by referencing contemporaneous statements by academics, regulators, investors, legislators, bankers, even Robert Shiller (the famous 'housing bear' whose meek warning highlights how common the insanity was). I don't think it is reasonable to legally punish someone for holding conventional views, because incorrect conventional views are so common, if such errors were actionable we should just turn over corporate revenues to the trial lawyers right now. As a practical matter, the scope of damages is too large given the historical stupidity of conventional wisdom (busing, new math, socialism).

One thing I wish the Agencies were pressed on, is presenting the performance of their ratings in a standardized way. Currently, the agencies get to present their opinion on their opinions, and this cannot be anything but biased. For example, from 1993-2007 (the latest data available), Moody's cumulative 5-year 'impairment' rate on Residential Mortgage Backed Securities is 0%; for corporate ratings, the 5-year 'default' rate 0.09%. As they said in The Princess Bride, I don't think those words mean what you think they mean.

The problem is the universe of things to rate is very complicated. As a practical matter, you do not want to include Municipal bonds, with sovereign ratings, corporate, and structured finance. Even within structured finance, you want to disaggregate credit cards from commercial real estate. This is because the criteria, the model, the data, one applies to these areas is very different, so the relevance of a AAA for the IBMs of the world, is very different than the AAA applied to Structured Investment Vehicles. One might say, an AAA should mean the same thing, and they do attempt to mean the same thing. But they are very different problems, like estimating the probability Democrats with the presidency in 2016 vs. the probability global temperatures rise by 1 degree Celsius over the next 50 years. AAA targeted default rates are so low, you can't calibrate these empirically, you just make your best estimate in very different domains.

The net result is that when the agencies present their data they exclude various securities that are not obvious, leading to selection biases that are parochial and difficult to tease out. The exclusions are invariably favorable to the rating agencies reputations. I'm sure that, under some definition, the AAA default rate for structured securities is 0%. I'm sure using another, it is much higher. One thing regulators could do is to define for the agencies how this is calculated. Indeed, they should get all ratings data, and performance data, and generate a timely report card. That would be something useful and straightforward for our legions of regulators to do, and given the special status accorded to ratings agencies by the government, not an unreasonable intrusion.

There are many lawsuits in the pipeline, more than the value of the rating agencies. It would not be best for the economy to kill Moody's, Fitch, and S&P, because new firms would have the same analytical problem they face today, only with less institutional experience with a failure that is helpful to have internalized. These institutions are very helpful, because without them there would be much less liquidity in these obligations, and liquidity helps increase intermediation, and getting savings to companies efficiently makes our economy work better.

Comments

[Jim Van Mee...:]

Eric: I think you miss a very important factor regarding the American judicial system. A jury will determine if their assuptions were reasonable. I'm disappointed in the rating agencies. I don't think they did a professional job. Any business school graduate using Generally Accepted Auditing Procedures could have done a better job

Sep 04 04:00 PM

[Gtarras:]

" am very sympathetic to the Rating Agencies because I know that in general Moody's is filled with thoughtful, sincere people, who because of their culture, have better ethics than your average investment banker. "

absolutely agree with your assessment of the employees at the CRAs. i personally know a lot of these folks and they are much much more honest than your average banker.

Sep 04 08:01 PM

[Gtarras:]

"Potentially, there is negligence and bad faith involved. If I were the rating agencies, I would argue this was merely a good faith error, and highlight how conventional their opinions were by referencing contemporaneous statements by academics, regulators, investors, legislators, bankers, even Robert Shiller (the famous 'housing bear' whose meek warning highlights how common the insanity was). "

their models and assumptions were very transparent and available to anybody interested. the folks who blame them for the losses they suffered never cared to check them, i guess, and now are looking for somebody to blame and point fingers at. i am not saying that the CRAs did not screw up. they did, big time. but their errors are not as criminal as many people are trying to make them out to be.

Sep 04 08:06 PM

[Mistrofan:]

Eric - excellent article! Outstanding. Indeed - the first stepts preparing the Great Depresion II are being made as we speak! One necessary step is/was to exclude any potential broadly recgnized voice taht can say somethig about the wrong financing structure of many companies, states and municipalities.

Sep 04 11:38 PM

[MktMaven:]

We warned about CRAs and their potentially negative impact in comments to the SEC in 2005:

"Envy, hatred, and greed continue to flourish in certain capital market institutions, propelling ethical standards of behavior downward. Without meaningful reform there is a small, but significant and growing, risk that our economic system will simply cease functioning."

May 23, 2005. See: sec.gov/rules/proposed...

Sep 05 10:22 AM

[misther:]

Your paragraph that begins with the sentence,
"I am not sympathetic to the 'free speech' gambit"
seems poorly written. And the judge's comment seems
nonsensical. Moody's publishes opinions. They do not
write newspaper articles. If somebody says "I think the
earth is flat" and another pays that person to get his opinion,
that does not mean the buyer is excused from doing his own
thinking. What next? Well a person who buys a book where
the author says, "Here's how to make a million dollars", now be
able to file a lawsuit against the author, saying you left out some
important details? Odd word, lawsuit...Can you wear a law?
Much of your essay states facts, but you leave out the most
important fact: Moody's publishes opinions. Nobody had to
believe anything Moody's said. That is why they publish a "track
record" as evidence of why their opinions should be taken
seriously. But really, the financial world is full of people who
refuse to do their own thinking, and want somebody else to blame
when things go wrong. "I listened to that guy, and look what
happened..." How intelligent are judges, and juries, with respect
to matters of finance, economics, or global warming?

Sep 08 03:37 PM

[misther:]

Moody's success, past, present, and future is predicated
on its ability to protect its reputation. And the only way
Moody's can do that is to cultivate a successful track
record. In other words, the company is self-policing.

Their inability to state the true reality means others may not
care now whether a security is listed as AAA or Caa. And
that in turn will have dire consequences for what is called,
American Capitalism. But nobody is asking, Is Moody's
run by Marxist-Leninists? Was this an act of white-collar
terrorism? Well, I just did.

Rather than attack Moody's, why not question the people
who relied on Moody's opinions to make their investment
decisions? Ask them, what prevented you from doing your
own thinking and realizing that when the crowd buys stocks
on margin, asset price bubbles occur, hence, why should
real estate prices lifted by easy access to credit be any
different?

Sep 08 03:44 PM

[misther:]

Imagine a world without Moody's. Now, how would that
be a good thing? Would you rather the government
create a rating agency instead? What makes you think
those analysts, most likely former employees of Moody's
(since analysts who know what they are doing are difficult
to find), would do any better?

Sep 08 03:47 PM

[misther:]

Somebody wrote, Any business school graduate using
GAAP could have done a better job...Maybe. But then
maybe any janitor working at Nordstrom's could also have
done a better job...How does knowledge of GAAP help you
figure out whether a company will still exist 5 years from now.
Look at Ford Motor Company. Their total debt is listed at
$100 billion US, yet they "keep on ticking". Whereas Sirius XM
is trying to keep from filing for bankruptcy, even though the
economics of satellite radio are phenomenal compared to the
car manufacturers. Economic theory, and an understanding
of political objectives in the arena of human nature, are more
likely to help an analyst than say, GAAP, which some study in
progressive high schools.

Sep 08 03:53 PM

[misther:]

With only a few billion dollars of debt, CEO Karmazin
of Sirius signed up Howard Stern for $100 million, and
then sold much of the company to Liberty Media for a
few hundred million more...And business reporters call
him brilliant. Why didn't he just ask Ford for a few billion
dollars in exchange for royalty-free satellite radio in their
cars for the next five years? Given that Ford already has
borrowed a $100 billion US over the last few decades, and
not paid it back, what's a few billion more? Especially if
that would have made their cars more attractive to the consumer
than a satellite subscription on a vehicle by Toyota. What I
see is the systematic destruction of what has been called,
American Capitalism. But is this good, or bad?

Sep 08 03:57 PM

[misther:]

Did you ever read Sun Tzu?
- Gordon Gecko to Bud Fox, in the movie, Wall Street.

Sep 08 03:59 PM

[misther:]

Mkt. Maven wrote:

"Envy, hatred, and greed continue to flourish in certain capital market institutions, propelling ethical standards of behavior downward. Without meaningful reform there is a small, but significant and growing, risk that our economic system will
simply cease functioning.

Sounds like the plot to a movie called, Zombieland.

Sep 08 04:09 PM

[misther:]

"Envy, hatred, and greed continue to flourish in certain capital market institutions, propelling ethical standards of behavior downward. Without meaningful reform there is a small, but significant and growing, risk that our economic system will
simply cease functioning."

The above statement has been true, I think, for at least two
hundred years. And during those centuries, "meaningful reform"
has come about. From genocidal policies directed against the
aboriginal populations to the New Deal. Two things now threaten
the present system: A collapsing US dollar, and growing trade
deficits with "the rest of the world". Although a devalued dollar
might help real estate prices recover as foreign investment poors
in, in an attempt to capture a piece of the American Empire
(especially land, and stocks) before their US dollar holdings
become worthless. Lots of cash-rich Canadians, I imagine,
escaped the meltdown in America.

Sep 08 04:21 PM

[misther:]

GAAP: Generally Accepted Accounting Principles

Jim Mee (not his real name, no doubt) wrote,
"Generally Accepted Auditing Procedures"...???

You mean auditors have a method? Well, if you
know the method, then you can hide from the auditor,
I think. For you will know where they are going to look.

Sep 08 04:26 PM