CalPERS blames rating agencies


Jan. 21, 2010


In recent congressional hearings, inaccurate credit ratings were described as a major contributing factor in bringing the nation to the “brink of financial collapse.”

In September, California Attorney General Jerry Brown opened an investigation into the rating agencies’ role in fueling the financial crisis – hoping to determine if the firms broke the law when they “recklessly gave stellar ratings to shaky assets.”

Now, a legal battle between the rating agencies – known as the globe’s second “superpower” – and one of the most “sophisticated and powerful investors” on the planet promises to provide a behind-the-scenes look into the world of high finance at the center of the financial meltdown.

Robert Fellmeth, the Price Professor of Public Interest Law at the University of San Diego Law School, said the lawsuit recently filed by the California Public Employees’ Retirement System against Standard & Poor’s, Moody’s and Fitch Ratings involves the “most important ethical issue of our time.”

“I think one of the lessons we’ll learn from this case is the inherent problems that conflicts of interest pose in our commercial sector – including the reliance on credit reporting agencies that are financially profiting from the instruments they are rating,” Fellmeth said. “We have lots of problems that were exacerbated by this heads-I-win, tails-you-lose structure. One of the safeguards is supposed to be these credit reporting agencies, which failed so miserably.”

In the lawsuit, CalPERS alleged it purchased $1.3 billion in “structured investment vehicles” with top credit ratings that turned out to be “wildly inaccurate.” The nation’s largest pension fund alleges it was only after it lost more than $1 billion that it learned the underlying assets consisted of subprime mortgages and other risky investments.

The case comes as CalPERS is under increased scrutiny for record losses involving risky leveraged investments and allegations of undue influence by placement agents.

“This lawsuit shows a basic mismanagement in their investment department,” said Marcia Fritz, president of the California Foundation for Fiscal Responsibility. “They have made changes in management and are implementing new standards of quality control to make sure they don’t make these mistakes again. But the losses are on the backs of the taxpayers. That is the tragedy of it.”

Late last week, the attorneys for the rating agencies filed a motion to dismiss the CalPERS lawsuit.

“The claim is without legal or factual merit and we are taking action to have it dismissed,” said Frank Briamonte, spokesman for The McGraw-Hill Companies, the parent company of Standard & Poor’s.
Fitch Ratings declined to comment.

“Moody’s believes that it has strong defenses to the CalPERS litigation and is moving to dismiss the complaint,” Moody’s spokesman Michael N. Adler said.

In the motion to dismiss, the attorneys for the rating agencies wrote CalPERS is asking the court to do what no other court has ever done: find that the rating agencies, which publish opinions about the likelihood securities will pay off, are liable when those investments go south. In similar cases, courts have ruled in the rating agencies’ favor, finding their opinions are generally entitled to the same level of free speech protections enjoyed by newspapers and other media.

The attorneys alleged CalPERS is seeking damages for its own failure to act as a prudent investor on behalf of 1.6 million public employees and retirees. The fund, now valued at $200 billion, is down 26 percent from a high of $270 billion in 2007.

“Under the circumstances, CalPERS’ allegations of its sole reliance on credit rating agency ratings coupled with its frank – and remarkable – admission that it had no knowledge of the SIV’s assets and made no inquiry beyond the ratings cannot be justified as a matter of law,” the rating agencies’ attorneys wrote.
In the CalPERS lawsuit, San Francisco attorney Joseph J. Tabacco, Jr. wrote the pension fund relied on top ratings given by the rating agencies in purchasing the SIVs.

“The rating agencies … were indispensable players in the structuring and issuance of SIV debt, which they subsequently rated for huge fees paid by the issuers – ‘rating their own work’ according to a recent Securities and Exchange Commission report highly-critical of the rating agencies,” Tabacco wrote.

In the past, investors paid a subscription fee to the rating agencies for access to the ratings. In the 1970s, the agencies moved to a model in which the agencies are paid by the issuers whose debt is receiving the rating. In 2000, the agencies became involved in the creation and operation of SIVs, Tabacco wrote.

“Structured finance was lucrative,” Tabacco wrote. “Rating a typical SIV commanded $300,000 to $500,000 or more, and some fees for rating SIVs claimed to the $1 million level…. What is more, the fees were contingent on the SIV ultimately being offered to investors. This meant the rating agencies had a contingent fee interest and thus every incentive to give high ‘investment grade’ ratings, or else they wouldn’t receive their full fee.”

The fees became the dominant source of income for Moody’s and Fitch. In the first quarter of 2007, SIVs accounted for 53 percent of Moody’s revenue. From 2000 to 2007, Moody’s operating margins averaged 53 percent, Tabacco wrote.

“These margins outpaced those of Exxon and Microsoft,” Tabacco wrote. “For five years in a row, Moody’s had the highest profit margin of any company in the S & P 500.”

Quoting internal S & P documents, Tabacco wrote analysts openly mocked SIVs, saying “it could be structured by cows and we would rate it” and “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In an October 2008 hearing before the House Oversight and Government Committee, U. S. Rep. Henry A. Waxman, D-Calif., testified the rating agencies revenues doubled from $3 billion in 2002 to more than $6 billion in 2007.

“The story of the credit rating agencies is a story of colossal failure,” Waxman testified.

In September, the committee held another hearing to examine what role inaccurate credit ratings played in the financial crisis. CalPERS Senior Investment Officer Eric Baggesen testified the “market impact of credit ratings failures” have been estimated at anywhere from $2.5 to $4 trillion worldwide.

“The … rating agencies … and their excessively optimistic ratings of subprime residential mortgage-backed securities in the middle years of this decade played a central role in the financial debacle of the past two years,” testified Lawrence J. White, a professor of economics at the Stern School of Business at New York University.

In response, CalPERS is seeking congressional support for legislation – “The Wall Street Reform and Consumer Protection Act of 2009” – to plug regulatory gaps and prevent the corporate malpractice that contributed to the nation’s financial crisis. It calls for a new SEC office to oversee credit rating agencies.
In September, the SEC Commission voted to take several actions to bolster oversight of the rating agencies. The proposed measures are intended to improve the quality of credit ratings by requiring greater disclosure, fostering competition, helping to address conflicts of interest, shedding light on rating shopping and promoting accountability.

But Orange County Supervisor John Moorlach said he doesn’t have much confidence the SEC’s actions will hold rating agencies accountable.

While the CalPERS lawsuit is not an ideal solution, Fellmeth said it could help the pension fund recover some of its losses and help reduce its unfunded liabilities – a tab that will require the state to increase taxes on “our children and grandchildren” in a “wealth transfer between generations.”

For Fellmeth, the real solution is to make the rating agencies independent of the companies and investments they rate. Instead of the current model, Fellmeth suggested businesses that want the services of the rating agencies to pay into a neutral, third-party fund. The fund would pay the rating agencies.

“You’d have an independent fund that could not be influenced and there wouldn’t be any impact on the rating agencies’ bottom lines based on what they say,” Fellmeth said. “You’d have a system that provides accurate information.”

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