There is a sense of karma and justice in the new lawsuits being pursued by the American government against S&P. The rationale for the lawsuit is that the ratings that were given to some of the securities that led to the financial crisis of 2008 and has not been answerable to anyone till now. During the crisis, some of the CDO and CDO squared securities were given a rating of AAA- or even AAA which makes them safe enough to be invested in by many of the financial institutions. On top of this, further financial instruments were created which were indexed to the ratings which proved to be like building higher structures on shaky basis.
Due to lack of due diligence and scrutiny by the rating agencies, the securities got ratings much higher than they deserved. In addition to that, many financial institutions also invested in these securities relying on the ratings to be a true reflection and lost many of its participant’s investments like pension and employee funds. So on the basis of misinformation and a lot of smoke and mirrors, the investment community was basing their decisions on these rating. The lawsuit states that false ratings were released and even thought there was a lack of research and an element of bias involved in them, this was not told to the investors.
People do not need to know which side of the issue they stand on as it seems much more black and white rather than being painted in shades of grey. The element of David and Goliath runs deep in this lawsuit where the underdog is taking on a stronger power. It seems that even though the gusto is commendable, the case that can be made by the US government is weak. First of all, S&P can sell any rating they want. It is under the First Amendment that their free speech is protected under and they are protected under it.
In addition to that, the complexity of the financial products used makes them circular. For example, AIG rights a bond. Some like Goldman buys that bond and then repackages it into a CDS and sells it to someone else. The CDS pays the buyer in case the bond fails. Simple enough. But what if AIG buys the CDS on its own bond. How can it be argued that AIG was sold a bond that was bad? A bond that they wrote in the first place. In addition, it is difficult to argue that huge corporations like AIG, Citigroup took the ratings on their faces without researching them any further.
Lastly, an opinion by a ratings agency is just that. An opinion based on its own analysis. It’s the people who give it credibility by agreeing to it so the buyers should be caution when they act on it rather than the seller of the rating.
The only grounds that can be used against the rating agencies is the conflict of interest that is inherent in the system where the bond issuer pays for the ratings himself and so will get the rating he desires. The values he gets to show on his balance sheet and meet regulatory requirements depend on the ratings and so they have an incentive to get higher ratings. The rating agencies comply with this by working on a commission basis and earning their returns by going along with the companies.
It seems that this is only small step towards better and more effective reform but it is a step none the less and is aimed at working towards a more equitable environment. In conjunction with the Dodd Frank act which can tighten the noose around the necks of the culprits of the financial crisis, things will only get better for the future. There is still a long way to go and both the judicial and the legislature need to work in tandem with the financial industry to avoid another financial crisis in the future.
One of the most effective measures can be to make the ratings agencies independent bodies or make them work under an authority so that the body can fund and carry out the ratings process. This will at least eliminate the perception of conflict of interest.