Friday, September 04, 2009

Ratings Agencies Lose 'Free Speech' Immunity

From the WSJ, an important ruling affecting the backlog of lawsuits against Moody's, S&P, 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.


Don said...

What I am fascinated with is the legal point about "general circulation" aspect to the judges decision. There was a very famous Supreme Court decision back in 1985 (at least famous with regard to the financial community) that changed the way investment advisors were regulated. Basically, the Court said that anyone who gave investment advice did not have to register with the SEC, as long as their ideas were disseminated to a general audience. Basically, it put newsletter writers like Prechter and Granville on par with the folks that wrote "Heard on the Street" or someone like Dan Dorfman or Gene Marcial. The key was the general circulation. If you only sell your research to certain individuals or entities, then the first amendment protection disappears, at least from a regulatory point of view.

If these ratings reports were not available to the general public, and only available to institutional investors, then the ratings agencies have a battle on their hands.

Lowe v. SEC, 472 U.S. 181 (1985)

Anonymous said...

they exist as a result of a govt sponsored oligopoly. i have zero sympathy for them.

Plamen said...

Great post, minus the sympathy for them.

I do not think the rating agencies should be sued out of business; I think they should be "revenued" out of business, since their models were clearly garbage, and they have to do a helluva lot more than they are to convince anyone that they have learned from this debacle. But that would be an admission of error, and we cannot have that, can we now?

bjk said...

Before the seventies these companies were worthless. Right now they are worth something because they serve a gatekeeper function. But why not just put the data out on the web and let different ratings firms establish track records? Egan Jones and Gimme Credit are probably better credit raters than Moodys and S&P, let them get in on the ratings game. Once a gatekeeper is appointed then some sort of capture is inevitable, not to mention the outrageous fees they receive. Before the 70s Moodys and S&P had trouble giving away their product.

bjk said...

It's also likely many of these products would be much simpler in the absence of S&P and Moody's. The market would demand it . . .

David Merkel said...

Eric, you are 100% correct. The free speech argument is wrong, but investment analysts should not be prosecuted for their opinions, unless they were intentionally lying.

Mere stupidity, even if there is a monetary interest, should not be a crime.

I write this as a former corporate and mortgage bond manager. Savvy managers, who represent most of the market, do not rely on ratings -- they rely one their own analysts.

Ratings affect risk-based capital, CDOs, and investment policies, which have to have simplifiying assumptions on credit in order to work.

The rating agencies should survive this. Unless the Feds want to set up a public rating agency for RBC purposes (a horror, consider how badly the NAIC failed), they have to rely on external ratings to set capital levels.

Anonymous said...

"Mere stupidity, even if there is a monetary interest, should not be a crime."

As far as I know, the government is not attempting to throw anyone in jail. These are civil suits - money only.

radix023 said...

You're being far too generous. Please see:

Bill Black, the guy who lowered the boom on the S&L mess details just how bad the 'work' done for those ratings was. Long, but worth it.

Ritholtz said...

Sorry to disagree with the lovefest here, but this is absurd drivel.

The Rating Agencies were the prime enablers of the entire crisis. BUT FOR their slapping triple AAA onto junk, much of the crisis COULD NOT HAVE OCCURRED.

The vast majority of the buyers of this mislabeled junk were precluded from buying non-investment rated paper.

Hence, the Ratings agencies failed in their primary charge: Providing insightful, accurate ratings of credit risk. That failure was a major factor -- in providing a steady supply of securitized, sub prime based soon to be defaulting mortgage based paper.

This was not an honest error by an objective broker, it was PAYOLA. The nature of their fee structure with iBanks, they did so in large part because they were paid to.

They can easily be replaced. At the very least, their unique protected status needs to be dismantled.

bjk said...

Barry is right. And the current reform simply entrenches the incumbent ratings agencies. Their role stems from a misguided search for stability, which leads to more instability.

Eric Falkenstein said...

I don't think investors defer to agencies as much as you think. That is, they make their decisions purely based on AAA ratings.

Anonymous said...

i am all in favour of the ratings agencies. they encourage dumb money to pile into crap they don't understand. this creates alpha for the less dumb. a toast to S&P, moody's and the SEC.

Vernon Malcolm said...

It is the realtors and builders and mortgage brokers who need to be regulated by the Federal Reserve. Realtors did away with professional appraisors by lobbying for the right to do this themselves. Then they did away with the hard earned skills of professional engineers by getting themselves the right to do home inspections. They got themselves the right to do these things when they lack the decade of experience.