Discredited credit rating

While the business community may have thought that credit ratings agencies have successfully dodged their liability for erroneous ratings that contributed to the near financial meltdown of the United States in 2008, an Australian court recently doused that impression.

Early this month, the Federal Court of Australia ordered Standard & Poor’s (S&P) and investment bank ABN Amro to pay the equivalent of US$31 million to several Australian towns that bought securities from ABN earlier rated by S&P as AAA.

This rating means the issuers of the securities are financially stable and can be relied upon to pay the promised interest, and repay the principal, when they fall due.

The securities, described as “constant proportion debt obligations,” are by-products of the billions of dollars in mortgage housing loans that many US banks gave out to borrowers and homeowners with dubious credit standing.

ABN packaged and sold these securities in Australia in 2006, with the S&P credit rating bandied as a “seal of good housekeeping” for them.

Unfortunately, the US financial market unraveled in 2008 and the Australian towns were left holding the proverbial empty bag. The securities were not even worth the paper on which they were printed.

Omissions

The Australian towns sued S&P for damages on grounds that it negligently and misleadingly granted the “AAA” rating on the securities when a “junk rating” (i.e., there is a high risk of default on the notes) should have been issued.

S&P raised the “opinion defense” or the argument that it gave the subject credit rating after a fair, reasonable and independent evaluation of the merits of the securities and, therefore, cannot be faulted if their appraisal later turned out to be wrong.

At the trial, however, it was proven that several errors and omissions were committed by S&P during the rating process and that it had relied on the calculations and projections submitted by ABN to justify the issuance of the triple-A rating.

Thus, the Australian court ruled that S&P’s rating was “misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia.”

It stressed that the AAA rating “conveyed a representation that, in S&P’s opinion, the capacity of the notes to meet all financial obligations was ‘extremely strong’ and that S&P had reached this opinion based on reasonable grounds and as a result of an exercise of reasonable care when neither was true and S&P also knew not to be true at the time made.”

Consequences

This is the first time in the world that a court has found a ratings agency liable for giving a good credit rating on a financial instrument that is otherwise undeserving of that endorsement.

Until the Australian court’s ruling, S&P, Fitch Ratings and Moody’s Investor Services (the top three credit ratings companies in the world) have been able to elude or tie down in litigation the suits filed by the US Securities and Exchange Commission and several state governments against them for their role in the subprime housing mortgages scandal.

S&P and Moody’s tried, but failed, in August, to have a case filed against them in a US court dismissed based on the “opinion defense.”

The judge in that case said that “… if a rating agency knowingly issues a rating that is either unsupported by reasoned analysis or without a factual foundation it is stating a fact-based opinion that it does not believe to be true.

“Ratings are actionable if they both misstated the opinions or beliefs held by the rating agencies and were false or misleading with respect to the underlying subject matter they address.”

The Australian court’s ruling is expected to open the floodgate for the filing of similar suits against S&P and ABN (now the Royal Bank of Scotland) in Europe and the US where the same securities were rated and sold by the same parties.

Payback

Although long in coming, the judgment against S&P, and the rest of the rating agencies, in general, is fitting and proper. It’s time these companies are held accountable for their conspiratorial relationship with issuer of securities that resulted in the once-in-a-century financial maelstrom whose adverse effects are still being felt up to now.

The rating companies gave the credit rating the securities issuers wanted for their instruments, otherwise the latter would go to their competitors that would be willing—for the right price—to give the desired credit rating.

Since rating companies are profit centers, not charitable institutions, the due diligence and critical evaluation required of honest-to-goodness credit assessments were conveniently ignored.

When the roof fell and their involvement in the events that led to the financial crisis were exposed, the rating companies were quick to wash their hands of any culpability and claimed they merely gave opinions that the investors were free to accept or reject.

At present, issuances of securities by Philippine companies customarily carry credit ratings issued by domestic ratings agencies. Whether or not the rating issued adds value to or makes the securities attractive to investors is a big question mark.

The reputation of the people behind the securities offered to the public, not the rating given, determines the success or failure of the offering.

(Reminder to resident and alumni fellows of the Upsilon Sigma Phi: The joint jubilee celebration of batches ’57. ’62, ’67 and ’72 will be held on Dec. 12, 2012, at the Bahay ng Alumni, UP campus.)

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