Ratings agencies called into question

The US Justice Department has filed a lawsuit against the ratings agency Standard & Poor's (S&P) that endeavors to demonstrate before the courts that the agency deliberately overvalued the ratings of structured debt backed by subprime loans, defrauded investors and caused losses of more than 3.7 billion euros.

It is evident that this practice — consistent with underestimating the risks of complex products, and on occasions designed under the guidance of the agencies themselves — contributed to inflating the financial bubble and setting off a global economic crisis. Based on information and electronic mail between analysts and managers at S&P, the US justice system aims to demonstrate that the agency knew of the consequences of over inflating its ratings and that despite being aware of the destructive effects of this policy, continued to pursue it to make debt issuers happy and win market share.

The ratings agencies have so far defended their decisions before the US administration and investors caught up in the crisis using two arguments. Firstly, they argue that their analysis was mistaken in the same proportion that economic institutions such as the US Federal Reserve and other forecasting and research bodies got it wrong. That is, there was no deliberate distortion of the truth in order to boost their revenues. The second argument they have used is that investment decisions are always taken by clients and never the agency.

However, the new strategy adopted by the US justice system attacks the very assertion that intentionality cannot be demonstrated in the errors committed by the ratings agencies.

The messages unearthed by the investigators are a step in the right direction in dismantling the arguments of the agencies. If the lawsuit prospers and manages to show that there was intent to deceive, the consequences for the global system of rating financial assets will be devastating.

Radical reform

If this is the case, governments can call on precedents to demand hefty compensation as a form of reparation for the deceit suffered by investors. In addition, it would be politically incumbent on the economic authorities to overhaul the way companies in the ratings sector (S&P, Moody’s Investors Service and Fitch Ratings) operate.

The fundamental pillar of any reform must be to ensure that the role of the agencies is to supply appropriate information to both the buyers of financial assets and the issuers of them. In no case can rating agencies argue the need to defend the interests of issuers. The habitual practice of issuers defraying the costs of formulating the ratings of their debt issues can no longer be tolerated.

The revamp has to be radical to the point of segregating the corporate ownership of the process of assessment and recommendations from that of issuing ratings. This would signal the end of a way of understanding how the system of financial ratings should work.