Calpers Sues Over Ratings of Securities

July 15, 2009

Calpers Sues Over Ratings of Securities

SACRAMENTO — The nation’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies.

The suit from the California Public Employees Retirement System, or Calpers, a public fund known for its shareholder activism, is the latest sign of renewed scrutiny over the role that credit ratings agencies played in providing positive reports about risky securities issued during the subprime boom that have lost nearly all of their value.

The lawsuit, filed late last week in California Superior Court in San Francisco, is focused on a form of debt called structured investment vehicles, highly complex packages of securities made up of a variety of assets, including subprime mortgages. Calpers bought $1.3 billion of them in 2006; they collapsed in 2007 and 2008.

Calpers maintains that in giving these packages of securities the agencies’ highest credit rating, the three top ratings agencies — Moody’s Investors Service, Standard & Poor’s and Fitch — “made negligent misrepresentation” to the pension fund, which provides retirement benefits to 1.6 million public employees in California.

The AAA ratings given by the agencies “proved to be wildly inaccurate and unreasonably high,” according to the suit, which also said that the methods used by the rating agencies to assess these packages of securities “were seriously flawed in conception and incompetently applied.”

Calpers is seeking damages, but did not specify an amount. Steven Weiss, a spokesman for McGraw Hill, the parent company of Standard and Poor’s, said the company could not comment until it had been served and seen the complaint. Moody’s and Fitch did not respond to a request for comment.

As the Obama administration considers an overhaul of the financial regulatory system, credit rating agencies have come in for their share of the blame in the recent market collapse. Critics contend that, rather than being watchdogs, the agencies stamped high ratings on many securities linked to subprime mortgages and other forms of risky debt.

Their approval helped fuel a boom on Wall Street, which issued billions of dollars in these securities to investors who were unaware of their inherent risk. Lawmakers have conducted hearings and debated whether to impose stricter regulations on the agencies.

While the lawsuit is not the first against the credit rating agencies, some of which face litigation not only from investors in the securities they rated but from their own shareholders, too, it does lay out how an investor as sophisticated as Calpers, which has $173 billion in assets, could be led astray.

The security packages were so opaque that only the hedge funds that put them together — Sigma S.I.V. and Cheyne Capital Management in London, and Stanfield Capital Partners in New York — and the ratings agencies knew what the packages contained. Information about the securities in these packages was considered proprietary and not provided to the investors who bought them.

Calpers also criticized what contends are conflicts of interest by the rating agencies, which are paid by the companies issuing the securities — an arrangement that has come under fire as a disincentive for the agencies to be vigilant on behalf of investors.

In the case of these structured investment vehicles, the agencies went one step further: All three received lucrative fees for helping to structure the deals and then issued ratings on the deals they helped create.

Calpers said that the three agencies were “actively involved” in the creation of the Cheyne, Stanfield and Sigma securitized packages that they then gave their top credit ratings. Fees received by the ratings agencies for helping to construct these packages would typically range from $300,000 to $500,000 and up to $1 million for each deal.

These fees were on top of the revenue generated by the agencies for their more traditional work of issuing credit ratings, which in the case of complex securities like structured investment vehicles generated higher fees than for rating simpler securities.

“The ratings agencies no longer played a passive role but would help the arrangers structure their deals so that they could rate them as highly as possible,” according to the Calpers suit.

The suit also contends that the ratings agencies continued to publicly promote structured investment vehicles even while beginning to downgrade them. Ten days after Moody’s had downgraded some securitized packages in 2007, it issued a report titled “Structured Investment Vehicles: An Oasis of Calm in the Subprime Maelstrom.”

4 Responses

  1. An interesting reaction to problematic bankster (and ratings agency) intermediaries: Borrower, meet Investor.


    UPDATE 1-U.S. lawmaker questions issuer-paid credit ratings
    Mon Jul 13, 2009 3:41pm EDT
    (Adds comments from SEC chairman)

    By Joseph A. Giannone

    NEW YORK, July 13 (Reuters) – A key U.S. lawmaker on Monday questioned whether credit rating agencies such as Moody’s and Standard & Poor’s should continue to be paid by the big Wall Street banks that issue bonds and derivatives.

    U.S. Rep. Paul Kanjorski, a Democrat who chairs the House of Representatives capital markets subcommittee, told CNBC the agencies let investors down by putting triple-A stamps of approval on securities built on a foundation of financially stretched homeowners.

    When housing markets tumbled in late 2006 and these securities quickly plunged in value, critics complained the agencies were seduced by lucrative fees dished out by the Wall Street banks who paid for ratings.

    “Quite frankly, some of our rating agencies … I think they let us down, and the American People and the investment community know they let us down,” Kanjorski said in the TV interview.

    “We’re not going to correct this problem if in the future they can let us down again by the issuer paying the rating agency for the valuation.”

    Kanjorski could not be reached to elaborate on his comments.

    The CNBC discussion was prompted by a question submitted by hedge fund manager David Einhorn, who in May announced he was shorting the shares of Moody’s Corp (MCO.N: Quote, Profile, Research, Stock Buzz). He contends rating agencies have enjoyed an oligopoly nurtured by government.

    Einhorn, whose $5 billion hedge fund firm, Greenlight Capital, will profit if Moody’s stock falls, said the firm undercut the value of its own brand and primary product. Contacted by Reuters, he declined further comment.

    Congress and the Obama administration are scrambling to fix bank and financial market regulation that failed to rein in excesses in the boom years and left investors vulnerable to the continuing financial crisis.

    Rating agencies have been under fire for giving top grades to securities that proved to be very risky.

    Kanjorski said agencies were trusted by investors to provide an impartial analysis of securities, from corporate bonds to municipal debt. Instead, the agencies were seduced by the “hundreds of millions of dollars” in fees that could come from assigning good grades to asset-backed securities structured by the big banks, he said.

    While there has been talk of new rules, such as eliminating conflicts of interest by having investors pay for credit research, rating agencies have not been a front-burner issue in Washington.

    Last month, the agencies were largely spared in the Obama administration’s financial regulation overhaul. In a “white paper” that outlined its plans, the administration urged Moody’s Investors Service, McGraw-Hill Cos Inc (MHP.N: Quote, Profile, Research, Stock Buzz) unit S&P and Fimalac SA’s (LBCP.PA: Quote, Profile, Research, Stock Buzz) Fitch Ratings to bolster the integrity of their ratings, but did nothing to address the compensation issue.

    “I know Congress is in a position that we have to resolve it,” Kanjorski said. “The administration sent up their white paper and although it discussed in several paragraphs the rating agencies, it didn’t put nearly the weight on them nor the analysis of them.”

    U.S. Securities and Exchange Commission Chairman Mary Schapiro, testifying before Kanjorski’s committee on Monday, noted that the SEC had since February adopted measures to help bolster the credibility of ratings.

    One key concern is to prevent investment banks from securing inflated ratings by playing off agencies against each other, a practice known as “rating shopping,” she said. Schapiro directed SEC staff to explore new regulations in this area.

    “One possible approach would be to require disclosure by issuers of all pre-ratings obtained from (rating agencies) prior to selecting a firm to conduct a rating,” she said.

    Earlier this year the SEC called for steps to increase the transparency of how ratings are generated and barred some practices that create conflicts of interest.

    The SEC also proposed banning firms from rating a structured product paid for by an issuer, sponsor or underwriter unless they share that product information with their rival agencies, she said. (Reporting by Joseph Giannone; editing by John Wallace and Andre Grenon)

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