Holding the Credit Rating Agencies Accountable: A Glimpse Behind the Curtain

Contributed by: Ishwar Chidambaram, CFA

On 13th March 2014, the Mumbai Chapter of IAIP hosted Daniel S. Drosman, Partner from Robbins Geller Rudman & Dowd (RGRD), a world leading law firm representing institutional investors managing more than $ 2 Trillion in assets. It was a rare and exclusive chance to learn how credit rating agencies were brought to task for their fraud in assigning AAA ratings to notes backed by sub-prime loans that were sold in huge numbers to investors around the world (including in Asia). Daniel began by highlighting the complete breakdown of the bond of trust reposed in the 3 major US rating agencies, in the aftermath of the 2008 financial crisis. Indian and Asian banks lost a mind-numbing 90% of the value of their investments in Structured Products, over just six quarters in 2007-2008. Gold standard “Triple-A” ratings—touted to survive the Great Depression— collapsed within 6 months and had to be downgraded.

Cheyne Case

In August 2007, a structured investment vehicle (SIV) named Cheyne went bankrupt, causing heavy losses to investors. They filed suit, through RGRD, accusing ratings agencies of collaborating with banks to ensure that SIVs received ratings as high as “triple-A,” even though much of the underlying collateral was low-quality or subprime mortgage debt, and sought $638 MM of damages.

First Amendment

Until 2008, ratings agencies in the US enjoyed virtually carte blanche legal protection, thanks to their successful use of the First Amendment defense, pioneered by Floyd Abrams. This amendment, enshrined in the US Constitution, guarantees individuals and organizations the inviolable freedom of expression. But this loophole was abused by ratings agencies who manipulated it, and until 2009, got away with it by claiming that ratings issued were merely opinions based on educated guesses.

Crumbling Edifice

In 2009, in a landmark judgment, Federal Judge Shira Scheindlin passed a landmark ruling revoking the free speech shelter granted to ratings agencies. She ruled that ratings of the Cheyne SIV were not publicly disseminated and therefore not deserving of such protection.  This watershed ruling was made possible primarily through RGRD’s unearthing of critical, sensitive documents that belied the agencies’ claims of true independence and objectivity in issuing ratings.

Pandora’s Box

These documents clearly revealed widespread misrepresentation and outright fraud in rating the Cheney deal, as well as a lack of methodology for analyzing the debt securities in the SIV. Ratings were routinely bumped up to satisfy the firm marketing the deal (Morgan Stanley), while default tables were also regularly “tweaked” to avoid losing business from Cheney. In fact, internal emails by senior ratings analysts clearly highlighted the paucity of data to back the model’s assumptions. Analysts’ concerns over mundane issues like market share and losing deals pushed critical issues like model and rating accuracy to the backburner, resulting in a “Garbage In, Garbage Out” situation. The ratings agencies simply crumbled under pressure from investment banks, leading to total disconnect between ratings and reality. Success was defined as rating deals, irrespective of consequences, with disastrous results for unsuspecting investors.

Settlement and Aftermath

For the first time ever, S&P and Moody’s settled out of court, and agreed to pay hundreds of millions of dollars in damages. In a related development, the US Government sued S&P for $ 5 Bn,  alleging the firm ignored standards to rate mortgage bonds that imploded in the financial crisis and cost investors billions. In its defence, S&P accused the US Government of pursuing a vendetta in retaliation for the company’s downgrade of America’s debt in 2011.

The Event was well received by the enthusiastic audience.  It concluded with a Vote of Thanks followed by a networking dinner.

Click here for video link of the event: http://youtu.be/qTEIFI9_u-E

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