Court: CalPERS Can Sue Credit Rating Agencies Over Investment Losses

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CalPERS lost over $10 billion during the financial crisis, and many of those losses stemmed from financial instruments given top-notch ratings by ratings agencies Moody’s and Standard & Poor’s.

CalPERS filed a lawsuit against the agencies for assigning ratings that misrepresented the quality of the failed investments, but the lawsuit had been held up for months as the agencies appealed the suit’s legitimacy in the lower courts.

But on Wednesday, the California Supreme Court ruled that CalPERS could indeed sue the agencies. From the San Francisco Chronicle:

The lawsuit involved its $1.3 billion investment in 2006 in three financial products – Cheyne Finance, Stanfield Victoria Funding and Sigma Finance – that had gotten the highest ratings from Moody’s and Standard & Poor’s. They were securities issued by banks and management companies and available only in private offerings to a limited number of institutional investors, including the pension system.

Only after all three went bankrupt in 2007 and 2008, CalPERS said, did investors learn that the products’ assets consisted largely of high-risk subprime mortgages. The suit also alleged that the rating agencies’ fee agreements had a built-in bias, entitling them to full fees only if they issued passing grades.

The ratings agencies had argued that their ratings were a form of free speech. The court agreed, but pointed out an important qualifier:

While investment ratings are a form of free expression, said the First District Court of Appeal in San Francisco, they are not mere expressions of opinion or predictions of success, which are immune from negligence suits. Instead, the court said, the ratings are factual assertions, issued “from a position of superior knowledge” about the investments’ financial health, and thus can be challenged if made falsely and carelessly.

And while federal law prohibits states from regulating credit-rating agencies, damage claims for misrepresentation are “within a field traditionally occupied by the states,” Justice Martin Jenkins said in the 3-0 appellate ruling.

Both ratings agencies appealed the decision Wednesday, but the court denied their appeals.

SEC Tackles Asset Transparency, Conflict of Interest At Credit Rating Agencies

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The SEC is finalizing two new sets of rules today: one that would increase the transparency of the asset-backed securities that caused much grief for investors, including pension funds, during the financial crisis.

The other set of rules would improve the reliability of the ratings issued by credit rating agencies.

Pension funds and other institutional investors were hit hard during the financial crisis in part because they purchased highly rated but opaque securities that seemed safe but eventually became worth pennies on the dollar.

The new SEC rules aim to increase the transparency of those investment instruments, as Reuters reports:

The new rules would lay out which information issuers would have to provide to investors on the underlying assets in the securities – which can bundle thousands of assets such as auto or home loans – in a standardized format.

The newly required information includes the credit quality and the collateral and cash flows related to each asset, said the SEC.

The SEC first proposed new rules on asset-backed securities more than four years ago. But it has struggled to craft rules that balance privacy concerns about the disclosure of sensitive loan-level data with investors’ desire to know more about the securities.

The new rules would also give investors a three-day waiting period to back out once they had agreed to a transaction, and in some cases remove references to credit ratings.

The SEC is also finalizing rules dealing with conflicts of interest at credit rating agencies. The rating agencies have been accused by investors and watchdog groups of letting business interests influence the AAA ratings they gave to bonds that would later lose significant value. From the News Observer:

To address the conflict of interest, the new SEC rules would prevent the sales and marketing departments of credit-rating agencies from having anything to do with firms seeking a rating for their financial product. Among the provision of the new rules are tighter look-back requirements designed to discourage ratings agencies employees from going to work for companies whose product they’ve rated. Investigations by McClatchy Newspapers and subsequently regulators showed how Wall Street firms played ratings agencies off each other, threatening to give competitors their business unless they got the AAA rating they sought.

The rules relating to rating agencies have not yet been completed, but the SEC said it hopes to have them finalized by the end of Wednesday.

 

Photo by the SEC

Is S&P Downplaying the Instability of Local Governments Saddled With Pension Obligation?

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Local governments around the country are increasingly saddled with mounting debts due to outstanding pension obligations. So why are many of them seeing boosts in their credit ratings?

At least one credit analyst is wondering aloud whether rating agencies –specifically, S&P– are purposely downplaying the risk of investing with local governments. From Governing:

Since last fall, when S&P released new scoring criteria, the agency has been reassessing ratings for thousands of local governments. Generally, and as predicted by S&P itself, the new criteria resulted in more upgrades of governments than downgrades. But a Janney Montgomery Scott analyst pointed out in his July note on the bond market that those changes have not put S&P’s ratings more in line with competitors Moody’s Investors Service and Fitch Ratings.

In some cases, rather, agencies’ ratings scores for the same local governments have diverged even more.

“I do not remember a time when I saw so many credits with not just a one-or-so-notch difference here and there, but multiple-notch differences in some cases,” said Tom Kozlik, the analyst who wrote the note. “This is not part of the typical ratings cycle (where sometimes one rating agency is a little higher and vice versa, I suspect). As a result, I expect that rating shopping could be on the rise if the current trend continues.”

In other words, the fear is that S&P is going easy on local governments in hopes that those governments will prioritize S&P’s rating services over those of its main competitors, Moody’s and Fitch. If a government published only its highest rating, it can mislead investors as to the risk of an investment. And, that appears to be exactly what is happening. From Governing:

There has been a pattern of governments only publishing an S&P rating. In June, for example, there were a little more than 200 local governments that sold debt competitively. Of those, one-quarter of them only published an S&P rating, according to Kozlik’s review. Another 11 governments only published an S&P rating but also had an outstanding Moody’s rating within the past three years (Kozlik dismisses 16 cases where the outstanding Moody’s rating is prior to 2011).

Like S&P, Moody’s has also revamped its ratings criteria in the wake of the financial crisis, however changes have mostly focused on giving pension and other long-term liabilities more weight in the final score. Most local government pension liabilities shot up during the financial crisis and many have still not gained back much – if any – ground. This change has contributed to Moody’s issuing more downgrades.

S&P has been quick to defend their ratings. The man behind the ratings change talked to Governing about the controversy:

Jeff Previdi, the S&P managing director for local governments who spearheaded the agency’s criteria change, defended the process. He said that the criteria had been heavily tested and had gone through a public comment period. The new criteria scores municipalities in seven categories: management, economy, budgetary flexibility, institutional framework (governance), budgetary performance, liquidity and debt/liabilities. The score for economy counts for 30 percent of the total score; all other categories are given a 10 percent weight.

The intent was to make the process and scoring as transparent as possible, Previdi said. Additionally, he added, the upgrades have tended to outpace downgrades for a very simple reason: Governments are doing better now than when they were last assessed.

“When we are reviewing under the new criteria, we’re not working with the same metrics of the old criteria,” he said. “It’s not done in a vacuum. Over this time we’ve been in a generally positive environment for local governments — that’s informing some of the results you see.”

While S&P is upgrading many local governments, Moody’s has been doing the opposite: the agency has issued twice as many downgrades as upgrades, according to Kozlik.