Standard & Poor's is goin' down. Finally.

07/20/2009 2:50 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Thank you, CalPERS.

So far, the big three ratings companies, Standard &Poor’s, Moody’s (MCO), and Fitch have got off scot free despite their key role in the crisis that almost took down the world financial system. (You know the crisis that sent Lehman Bros. into bankruptcy and put taxpayers on the hook to bailout Citigroup (C) and American International Group (AIG). That crisis.) A suit brought by CalPERS, the California Public Employees’ Retirement System, is the best chance to yet to make the companies clean up their act.

CalPERS doesn’t face an easy task. Historically, the ratings companies have argued that their ratings of bonds and other debt instruments are merely opinions and as such are protected by the First Amendment. You can’t sue somebody for having an opinion, the courts have held, even if that opinion turns out to be wrong.

But the ratings companies got so greedy during the bubble years that their behavior, in my opinion, pierced that First Amendment protection.

Now a big institutional investor like CalPERS certainly knew that S&P, Moody’s, and Fitch had deep conflicts of interest and limited expertise that should have stamped every AAA-rating that these companies awarded “Use with caution.” The ratings companies were paid for their work not by the buyers of debt, pools of debt, and derivatives based on pools of debt but by the sellers. They knew that handing out an AAA rating would please their customers and that getting too tough would cost the rating company business. We’ve also heard enough anecdotal evidence to show that the analysts at the rating companies were frequently outgunned by the better paid folks on Wall Street who had built the products that they were being asked to rate. It’s pretty clear that in some cases the analysts didn’t fully understand what they were rating and had to take Wall Street’s word for it.

But the rating companies have survived lawsuits like this before amid general charges of conflicts of interest and incompetence. What’s different this time?

Well, at the height of the debt boom, when Wall Street was cranking out every more complicated and every more leveraged debt offerings, CalPERS’ suit alleges, the ratings agencies crossed the line from institutional and general conflicts of interest to specific behavior that clearly isn’t protected by their First Amendment defense. So, for example, the suit alleges, the rating companies gave the AAA stamp of approval to Structured Investment Vehicles (SIVs) from issuers such as Cheyne Finance, Stanfield Victory Funding, and Sigma Finance that were completely opaque to buyers. Only the rating companies and the companies that created the SIVs knew what the SIV owned. (In these three cases what they owned, despite the AAA rating, was subprime mortgages sliced and dice into various products.) That role of information insider, CalPERS argues, made the rating agencies into partners in the product and not simply issuers of opinions. (The CalPERS suit goes on to allege that the models that the rating companies used to give these SIVs their AAA ratings were seriously flawed and incompetently applied. Embarrassing, but not sufficient by itself to put the rating companies on the hook.)

Maybe. I’ll be interested in seeing how the court rules on that argument. But I think CalPERS has got the agencies dead on a second charge.

Rating SIVs was incredibly profitable for the rating companies who were paid their normal rating fee plus a premium of $300,000 to $500,000 to rate an SIV. That fee was only payable, the CalPERS suit says, if the SIV was ultimately offered to investors. No offering, no check.

To earn those fee, the CalPERS suit alleges, offering evidence from company insiders and financial expert, the companies went from being passive raters of products brought to the table by Wall Street to partners engaged in creating those products. “You start with a rating and build a deal around a rating,” the suit quotes Brian Clarkson, former chief operating officer of Moody’s as saying. The Securities & Exchange Commission has said that the rating companies were effectively “rating their own work.” “This is not passive process of rating corporate debt,” the suit quotes Charles Calomiris, Henry Kaufman professor of financial institutions at Columbia University as saying. “This is a financial engineering business.”

I don’t expect S&P, Moody’s, and Fitch to go down without a fight. Standard & Poor’s, for example, has hired famed First Amendment lawyer Floyd Abrams and the law firm Cahill Gordon & Reindel to argue its defense.

CalPERS, however, has the resources and the skin in this game to fight this one to the end.  

If CalPERS gets a big settlement, fine. Me, I’m just hoping for some reform of the rating companies. With teeth.

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