CalPERS Lawsuit Gets the Green Light

The California Public Employees’ Retirement System (CalPERS), the largest U.S. public pension fund, has won a court ruling allowing it to proceed with a lawsuit against the three main credit rating agencies for assigning “wildly inaccurate and unreasonably high” ratings. The ratings in question were regarding the AAA rating of three structured investment vehicles (SIV) in 2006 that allegedly caused the pension fund $1 billion in losses.

CalPERS is accusing the rating agencies of “negligent misrepresentations to CalPERS and CalPERS’ money manager agents, which have caused and will cause CalPERS to suffer substantial investment losses” by overvaluing the SIVs.

CalPERS claims that the agencies were the “only entities” outside those managing the SIVs who knew what assets were held by the opaque structures.

This is hilarious! CalPERS, a huge expert pension fund, was duped by too high of a rating? The California Treasurer complains the muni ratings of the NRSROs were too low!! This all looks like blame shifting.

New Amendment Targets Rating Agencies

Senators Al Franken (D-MN), Charles Schumer (D-NY), Bill Nelson (D-FL) and Roger Wicker (R-MS) have proposed an amendment to dismantle the “issuer pays” model that rating agencies currently use. The amendment would establish a Credit Rating Agency Board that would arbitrarily choose which rating agency would rate an issuer’s debt.

Taking aim at what they call a “permanent conflict of interest,” proponents of the amendment argue that this would make it more impartial as well as open up competition to smaller firms. The bipartisan proposal has received widespread support, including the endorsement of the Consumers Union consumer advocate group.

The rating agencies have unanimously come out against the amendment. “We believe the benefits of the issuer-paid model, combined with appropriate regulation, can far outweigh any potential conflicts of interest,” said Standard & Poor’s spokesman Ed Sweeney.

This is a bad idea (how come every problem can be solved with more government?). The only guys in America who didn’t know or understand this conflict existed were Franken, Schumer, Wicker, and Nelson. The new Board name should be aligned with the usefulness of the idea: Credit Rating Agency Panel.

France Blames Ratings Agencies for Aggravating Greek Credit Woes

Rating agencies have successively downgraded the sovereign debt of Portugal, Greece and Spain and this has, in part, led to a sharp devaluing of the euro. The European Union has protested that the lower ratings assigned to Greece, in particular, ignore the fundamental indicators of the Greek economy as well as the aid plan created by the euro zone and the International Monetary Fund.

When speaking on French radio Europe 1, French Economy Minister Christine Lagrade said that France will reinforce control over the rating agencies. “I think certain rules should be fixed … because we don’t degrade a country under the conditions that its rating has been degraded, that’s to precipitate purchases of sales 15 minutes before the close of trading, deplorable for the solidity of the market,” she explained.

In an interview with Le Monde, she also said that the downgrade 15 minutes before markets closed was “crime inducing” because it created a panic among those holding Greek bonds who thoughtlessly offloaded the investments before markets closed, driving values down even further.

Previous European Commissioner for Internal Market Regulation Michel Barnier expressed the opinion that rating agencies should be “disciplined and responsible in their evaluation process.” Mr. Barnier, also of France, had also mentioned that the European Union was considering creating Europe’s own rating agency to balance the valuation opinions of the American agencies.

Vive la France! This is like blaming the thermometer for the heat.

Buffet Defends Rating Agencies

Speaking at Berkshire Hathaway Inc.’s annual meeting, Chairman and CEO Warren Buffett defended the company’s maintenance of its stake in Moody’s Corporation.

Mr. Buffett said rating agencies “made the same mistake” that everyone else did in overvaluing the health of the housing market. However, he countered, Moody’s — as well as McGraw-Hill, Standard & Poor’s and Fimalac SA’s Fitch Ratings — possess strong pricing power and require little in capital needs.

“There is obviously a backlash against rating agencies,” he said. “If they are not forced to change the whole structure around them … in some dramatic way, [they are still] a pretty darn good business.”

Mr. Buffett also pointed out that Berkshire has “never paid any attention” to credit ratings for bonds. “We don’t think we should farm out — outsource — investment judgment,” he said.

Rating Agencies Point Out Catch-22

The investigations on Capitol Hill have turned to how the rating agencies publicly shared the computer models they used to devise ratings. Ostensibly, the practice ensures that banks and other issuing bonds aren’t surprised by a weak rating that can adversely affect their ability to sell. What the Senate Panel took issue with is how it opened the door for bankers to work backwards: tinkering with complex mortgage deals until the model delivered the desired rating.

David Weinfurter, a spokesman for Fitch Inc., defended his company by saying it had made its models public in response to demand for increased transparency. He also pointed out that a committee, not the models, ultimately assigned ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.”

Congress Commissions Ratings Study

As a compromise between the House wanting to abolish the mention of credit ratings in the Federal register, and the Senate, who tried to become MORE involved in the ratings process, Dodd-Frank (DONK) commissioned a study. The regulators have a year to study and report back to Congress about their use of NRSRO ratings.

We support Chairman Frank’s efforts to strike the reference and official use of ratings. Ratings can’t be corrupt and useless, AND be the source of regulatory measurement.

The study should model its answer on the NAIC solution to PMBS:

1. Ignore the rating
2. Find a reliable third party to price the assets
3.  Publish the results.

The NAIC has already solved the rating problem, and it works. Let’s just copy that.

Agencies Issue Advance Notice of Proposed Rulemaking… – Board of Governors of the Federal Reserve System, August 10, 2010

The Effects of Reform

So, after protecting ratings as a First Amendment opinion, Congress changed the 2300-page regulatory reform bill and exposed the raters to legal liability if the ratings don’t reflect an ultimate change in the price of the bonds, or a default (crank up the class action lawsuit machine…).

What does this mean? Can a bond holder sue an NRSRO if the market value of a bond declines after a downgrade?

It means that this chills the value of a rating, if it exposes the rater to monetary liability. It seems there is a loophole, however.

If the rating was not part of the submitted OS or documents submitted to the SEC, the rating would be legally exempted, since it was not officially part of the submitted deal documents.

This is a stupid, populist nod to the worst of Congressional impulses. AT BEST, it will raise the cost of credit, and make it less available. AT WORST, it will put lawyers in charge of credit allocation.

What’s next, broker/ dealer stock buy and sell ratings? Will realtors be subject to legal liability if a house depreciates after you buy it? Will Las Vegas odds makers be subject to legal action if the odds are wrong and you don’t win?

The only good news is municipal bonds would be exempt because they do not have to register with the SEC. 

Bond Sale? Don’t Quote Us, Request Credit Firms – WSJ.com, July 21, 2010

Angelides Backs Senate Ratings Clearing House

Phil Angelides, chairman of the Financial Crisis Inquiry Commission, said that he supports a provision included in a Senate-approved bank reform bill that creates a government clearinghouse for structured-finance products that need to be rated.

An investment bank that needed a rating for a structured mortgage product, for example, would submit a request for a rating agency to the credit board.  The board would then assign which rating agency would do the work.

The idea has been controversial. The goal is to break up the cycle of credit rating agencies providing inflated ratings to get repeat business. Opponents object to the intrusion of government and its bureaucracy into the ratings process and claiming that the process would still not necessarily lead to more accurate ratings.

A government ratings assignment board would slow down credit formation and make it more expensive. All market participants know that issuers “shopped” ratings. This is only news to D.C. The government ratings assignments will only slow down the process, for the worse.

EU Revises Rules on Rating Agencies

The European Commission has suggested a list of revisions to EU rules on credit rating agencies that would increase transparency and centralize European supervision. Should the proposals be enacted, the European Securities and Markets Authority (ESMA) would take over the supervision of rating agencies in Europe from national authorities. The ESMA is a new entity whose legislation is still being negotiated by member states and the European Parliament.

Commission President Jose Manuel Barroso has stated that a European credit rating agency is another possibility. “We are looking at the idea,” he said. “Is it normal to have only three relevant actors on such a sensitive issue where there is a great possibility of conflict of interest? Is it normal that all of them come from the same country?”

Any proposals along these lines are not expected before September.

Bad idea. Leave credit evaluation to the market participants. Eliminate NRSRO designations. Ban governmental endorsements of rating agencies. Delete the use and reference to ratings.

Buffett Testifies Before FCIC

Warren Buffett recently testified before the Financial Crisis Inquiry Commission (FCIC) alongside Raymond McDaniel, the CEO of Moody’s Corporation.

Apropos of the report that 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have now been downgraded below investment grade to junk status, the Commission asked Buffett what he thought of the provision in the bank reform bill that would regulate rating agencies.

Buffett responded that while he “hated” the current system, he wouldn’t go so far as to outright support the measure. “I don’t know the answer to that,” he said. “The wisdom of somebody picking out raters, is that going to be perfect? I don’t know.”

He added that, “When rating agencies come to Berkshire, they have me by the throat. I have no leverage whatsoever. If there were 10 agencies and I took the cheapest one, people would say ‘You took the cheapest, but they didn’t do the work,’ so it’s not an easy answer.”

Buffet’s testimony can be seen at: http://www.cspan.org/Watch/Media/2010/06/02/HP/A/33689/Financial+Crisis+Inquiry+Commission.aspx

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