Thursday, September 3, 2009

Court to allow lawsuit against Moody's, S&P to proceed (MCO, MHP)

AlphaNinja - Two of my favorite companies to hate, Standard & Poors and Moody's, are under pressure today after a judge ruled that a lawsuit against the firms may proceed. Unfortunately, the judge dismissed 10 out 11 claims. Shares of the two companies are selling off today, as they should be. Just last night I listened to a big fixed-income manager tout his firm's in-house ratings research, and how it identified problem credits months (even years) ahead of the "big 3" ratings agencies -->> yet another reason that these firms and their flawed/negligent ratings are becoming more useless by the day.

Sept. 3 (Bloomberg) -- A U.S. judge refused to dismiss a lawsuit against Moody’s Investors Service Inc. and Standard & Poor’s, rejecting arguments that investors can’t sue over deceptive ratings of private-placement notes because those opinions are protected by free-speech rights.

I'd buy the "free speech" argument if the firms weren't a protected monopoly thanks to the government limiting competition.

Without ruling on the merits of the lawsuit, the judge said opinions by the ratings companies may be the basis for a lawsuit “if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.” She said there are enough facts alleged against the two agencies and Morgan Stanley, the sixth-biggest U.S. bank by assets, for the lawsuit to go forward with evidence gathering needed for any trial.

As for whether the agencies believe in their ratings, here's their own thoughts on the matter, from a 2007 text message between S&P officials:

Official #1: Btw (by the way) that deal is ridiculous.
Official #2: I know right...model def (definitely) does not capture half the risk.
Official #1: We should not be rating it.
Official #2: We rate every deal. It could be structured by cows and we would rate it.

The fact that these guys are inept shouldn't be reason enough for a lawsuit --it's that they're peddling a product that they have no confidence in that is the issue. Here's some more detail from my May post Demise of the ratings agencies? (Wishful thinking but...):

Almost 2 years ago, Robert Rodriguez of First Pacific Advisors scared the pants off anyone listening to a lecture of his. I've pasted his associates' questions put to a Fitch official, regarding the models behind Fitch's ratings on Mortgage-Backed Securities. Fitch admits that their models would "start to break down" if home prices flattened out, and if housing prices went DOWN (crazy thought at the time), their model would "break down completely." Incredible.

"We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions. “What are the key drivers of your rating model?” They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years. My associate then asked, “What if HPA was flat for an extended period of time?” They responded that their model would start to break down. He then asked, “What if HPA were to decline 1% to 2% for an extended period of time?” They responded that their models would break down completely. He then asked, “With 2% depreciation, how far up the rating’s scale would it harm?” They responded that it might go as high as the AA or AAA tranches."

If any firms in the credit debacle deserve to be sued out of existence, it's the ratings agencies. I'll finish with a quote from money manager David Einhorn on the agencies:

"If your product is a stamp of approval where your highest rating is a curse to those that receive it, and is shunned by those who are supposed to use it, you have problems."

"The truth is that nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government created oligopoly and, often, because they are required to by law. As a classic oligopolist, Moody's earns exceedingly high margins while paying only the needed lip service to product quality. The real value of Moody's lies in its ability to cow the authorities into preserving its status."

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