Suing the Ratings Agencies, or Shorting to Zero

July 22nd, 2009 by

James Cullen

This is a long overdue follow-up to a previous post on whether or not the ratings agencies are good candidates to be sold short. CalPERS is suing Moody’s (MCO), S&P, and Fitch, saying that their ratings “proved to be wildly inaccurate and unreasonably high.”

Hindsight is 20/20. Are the ratings agencies legally liable for misjudging the risks to instruments they rated? After all, the lawsuit documents say that CalPERS relied on the “AAA/Aaa” ratings given to the SIVs they purchased. The ratings agencies have the special privilege of a protected franchise, but if CalPERS is truthful that it only invested in SIVs because of the rating, it should have been damn sure that the ratings were appropriate.

CalPERS goes on to say that the assets held by their SIVs were confidential, so there is no way they could have known about the risks of their investment assets. Why were they investing in securities whose value was dependent on something unknowable to them? I’m not an expert on fiduciary responsibilities, but admitting an ignorance of what was owned seems like a pretty clear breach of some basic tenants.

The failings aren’t all on CalPERS. There’s plenty of blame to go around, and the ratings agencies certainly share in that blame. Recovering losses from them, however, crosses a new line and establishes that they have a legal liability for the losses suffered by those whose money they were not managing. Except in cases of fraud, asset managers are not held liable for investment losses; why should the ratings agencies be any different?

Maybe Moody’s looks like an attractive short because it has a negative book value. The value of Moody’s, though, has no relation whatsoever to book value; it’s all about the earnings to be had from acting as a toll between issuers and the debt markets. You can’t put that on a balance sheet, and it’s going to be hard to kill off that advantage for several more years at a minimum – and Moody’s will make a lot of money during that time (this, I assume, is why Buffett owns so much of the stock).

Regulators want to change the relationship between issuers and raters to make it appear more arms-length. As long as the emphasis is on that, and not on explicitly hurting the profitability of the ratings business (as it is with healthcare), I find it hard to believe Moody’s is an attractive short. Right now, the best hope for that is an off-the-wall jury verdict in favor of CalPERS, which looks improbable if not legally impossible.

Court Documents - CalPERS v. Moody’s