Sunday, November 22, 2009

State of Ohio Sues Credit-Rating Agencies For Lost Money

Ohio Attorney General Richard Cordray has filed a lawsuit in federal court against the three top credit-rating agencies in the U.S.: Moody’s Investors Service, Standard & Poor’s and Fitch. Cordray announced the suit in a press release Friday, November 20 and alleges that improper actions by the agencies cost state pension and retirement funds $457 million. The suit only adds to the legal woes of the agencies, who have already been sued by a slew of private agencies for similar offenses.

In terms of last year’s financial crisis, credit-rating agencies were responsible for evaluating the mortgages that comprised mortgage-backed securities. That rating was then used as the only indicator of the mortgage’s value, which mortgage was subsequently packaged with others and sold as a security to investors. This process relied heavily on the accuracy of the rating, and as a result, the rating agency’s decision about a loan essentially determined whether or not the loan made it to Wall Street. In the wake of the recent financial crisis, these credit-rating agencies have made the shortlist of potential responsible parties. Credit-rating agencies have been blamed partially because they had a major conflict of interest in handing out good ratings, as they were paid by the banks requesting the ratings.

The suit alleges that the agencies’ pursuit of profit and Wall Street connections resulted in inflated ratings on toxic mortgage debt and that these ratings cost Ohio state pension funds a great deal. Court documents allege that the rating agencies gave false and misleading ratings (sometimes “triple-A” ratings) to securities they knew were risky. “Triple-A” ratings are those which indicate an almost zero risk of default. The suit quotes an S&P analyst’s statement made in 2007 saying that “it could be structured by cows and we would rate it,” presumably referring to the lax rating standards the company chose to use.

Rating agencies have defended themselves against fraud allegations in the past by arguing that their ratings constitute opinion and right to free speech and therefore warrant protected by the First Amendment of the U.S. Constitution. Ohio is the first state to sue the agencies. Jerry Brown, the Attorney General of California has publicly stated that he has considered filing suit against the rating agencies, focusing on whether the agencies violated California law.
As of yet, the credit-rating agencies have been successful in thwarting the cases against them. They have yet to lose a court case against anyone on the issue, winning on the argument that their ratings are simply opinions about the future, and therefore subject to free speech protections similar to those for journalists under the First Amendment. The Ohio lawsuit does have the advantage of coming after the financial crisis, and also argues that even though the statements were opinion, the First Amendment does not extend to intentional manipulation of financial markets.

Discussion Questions:
1) The suit alleges that unless the banks got the ratings that they requested on the loans submitted to the ratings agencies, the agencies would not receive full fees. Do you think the First Amendment claim wins out in that situation or does the conflict of interest and resulting fraud overcome that argument?

2) In hindsight, what could have been done to ensure that inaccurate ratings were not given? Is it the fault of the government for not regulating the agencies’ transactions?

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