Illinois Attorney General Sues S&P – Initial Thoughts

Credit risk ratings are becoming a risky business.

Yesterday’s filing of the complaint against S&P (MHP) centers, in essence, on the allegation of false advertising. Stepping in to this issue for a moment, one of the key defenses offered by the raters is that their ratings are protected under the First Amendment rights to express an opinion (their “speech”). But as law professor Eugene Volokh opines in his letter to the House Committee (May 2009) it is within the framework of commercial advertising that “speech aimed at proposing a commercial transaction – is much less constitutionally protected than other kinds of speech.”

In this case, the AG is not really focusing wholly on whether the ratings were wrong, as much as it’s saying that S&P advertised that it was following a certain code in ensuring the appropriate levels of independence and integrity were being brought to the ratings process.

A former SEC enforcement official, Pat Huddleston, once explained that "[when] I say the [financial] industry is dirty, I don't mean to imply everyone in the industry is dirty," … "[only] that the industry typically promises something it has no intention of delivering, which is a client-first way of operating." This is essentially what the complaint argues: that S&P “misrepresented its objectivity” while offering a service that was “materially different from what it purported to provide to the marketplace.”

This goes back, really, to the key reform measure Mark proposed before the Senate in 2009 – that rating agencies would do well to separate themselves from commercial interests, by building a formidable barrier around the ratings process.

First, put a “fire wall” around ratings analysis. The agencies have already separated their rating and non-rating businesses. This is fine but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals (like building market share). Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is virtually barricaded into an “ivory tower,” and kept safe from interference by any agenda other than getting the answer right. The best reform proposal must exclude business managers from involvement in any aspect of rating analysis and, critically also, from any role in decisions about analyst pay, performance and promotions.

Two other elements jump out immediately from the complaint:

First, the complaint specifically argues that the rating agency “misrepresented the factors it considered when evaluating structured finance securities.” Next, the complaint tries to tie S&P’s actions to its publicly-advertised code of conduct, arguing that its actions were inconsistent with the advertised code.

In respect of actions being inconsistent with the code, certain of these arguments are common-place, such as the contention that the rating agencies did not allocate adequate personnel, in opposition to what’s advertised in the code. This of course becomes a contentious issue – you can see S&P coming back with copious evidence of situations in which they did “allocate adequate personnel and financial resources.” But the complaint hones in on the factors considered in producing a rating, and it focuses on two parts of the code:

Section 2.1 of S&P’s Code states: “[S&P] shall not forbear or refrain from taking a Rating Action, if appropriate, based on the potential effect (economic, political, or otherwise) of the Rating Action on [S&P], an issuer, an investor, or other market participant.”

and…

Section 2.1 of S&P’s Code states: “The determination of a rating by a rating committee shall be based only on factors known to the rating committee that are believed by it to be relevant to the credit analysis.”

This brings back to mind, disturbingly, a recent New York Times article (Ratings Firms Misread Signs of Greek Woes) which focuses on the deliberations within Moody’s (MCO) and their concerns about the deeper repercussions of downgrading Greece – rather than the specifics of credit analysis:

“The timing and size of subsequent downgrades depended on which position would dominate in rating committees — those that thought the situation had gotten out of control, and that sharp downgrades were necessary, versus those that thought that not helping Greece or assisting it in a way that would damage confidence would be suicidal for a financially interconnected area such as the euro zone,” Mr. Cailleteau wrote in an e-mail.”

The question then, is whether rating committees were focused on credit analysis, or whether other concerns were at play, aside even from typical business interests. The concerns for rating agencies, from a legal perspective, can become quite real when the debate centers not on ratings accuracy, but on whether the rating accurately reflected their then-current publicly available methodology. There may be substantial risks, therefore, in delaying a downgrade of a systemically important sovereignty or institution (such as a too-big-to-fail bank or a key insurance company) if such downgrade is appropriate per the financial condition of the company or sovereignty, or in providing favorable treatment to certain companies or sovereignties based on the relative level of interconnectedness.

The allegations of misrepresenting factors considered in their analysis opens another can of worms for rating agencies, as they’ll subsequently be increasingly focused on disclosing the sources of the information relied upon. There’s substantial concern, to the extent they’re relying on the issuing entity (in cases in which the issuing entity is itself the paying customer), that such reliance becomes a disclosure issue to the extent the investor may otherwise have assumed the rating agency was independently verifying such information. This was a frequent problem in the world of structured finance CDOs such as those described in the AG’s complaint.

Last, but not least, the complaint focuses on the effectiveness of ratings surveillance. This is a topic of importance to us, as we feel that proper surveillance, alone, may have substantially diminished the magnitude of the crisis. At the very least, certain securitizations that ultimately failed may not have been executed had underlying ratings been appropriately monitored, and several resecuritizations may have become impossible, limiting the the proliferation of so-called toxic assets. See for example: Barriers to Adequate Ratings Surveillance

That’s all for now. There’s a lot more to this complaint, so we suggest you check it out here.

The Mortgage Litigation Hangover (and who knew what, when)

Aside from the relatively new foreclosure disputes, including those relating to MERS, the big banks continue to suffer the ill-effects of lawsuits relating to their original portfolio selection and sale of mortgage-backed securities (and derivatives thereof, like ABS CDOs).

A number of these cases were dismissed last year, as judges often failed to sympathesize with the plaintiff's arguments that they were "duped." On the back of Congressional and FCIC-related testimony, plaintiffs have been able to strengthen their arguments as they search for viable legal theories that satisfy these, potentially higher, pleading standards.

Today's two cases filed today focus on the what they believe were material informational asymmetries between the buyers and sellers, and possible scienter on the side of the sellers.

In John Hancock Life Insurance Co. v. JPMorgan Chase & Co., 650195/2012, New York state Supreme Court (Manhattan), the complaint argues that:

Defendants JPMorgan, Bear Stearns, WaMu, and Long Beach knew about the poor quality of the loans they securitized and sold to investors like Plaintiffs, because in order to continue to keep their scheme running, they completely vertically integrated their RMBS operations by having affiliated entities at every stage of the process. In addition, Defendants JPMorgan, Bear Stearns, WaMu, and Long Beach were aware of lending abuses on the part of the third party originators they purchased loans from due to, inter alia, their financial ties to the third party originators and their reviews of loan documentation and performance.

In Sealink Funding Ltd. v. Morgan Stanley, 650196/2012, New York state Supreme Court (Manhattan), the plaintiff contends that because the seller never disclosed certain of its practices to the investors, the "investors were not compensated for the additional risks that they unknowingly took on in purchasing those Morgan Stanley RMBS."

Morgan Stanley knew or recklessly disregarded that those lenders were issuing high-risk loans that did not conform to their respective underwriting standards. Morgan Stanley did, in fact, conduct extensive due diligence on the loans it purchased for securitization, as represented in the Offering Materials. In the course of that extensive due diligence process, which, in many instances, included an extensive re-underwriting review of the loans it purchased by an independent third-party due diligence provider, Clayton Holdings, Inc. (“Clayton”), Morgan Stanley learned that the originators routinely and flagrantly disregarded their own underwriting guidelines, originated loans based on wildly inflated appraisal values, and manipulated the underwriting process in order to issue loans to borrowers who had no plausible means to repay them. Indeed, both the President of Clayton and the head of Morgan Stanley’s own due diligence arm testified as to the extensive deficiencies identified through Morgan Stanley’s due diligence. Specifically, over one-third of the loans Morgan Stanley evaluated for purchase and securitization at the height of the mortgage boom (from 2006 through mid-2007) failed to meet the originators’ own underwriting guidelines.

We concentrated on the effectiveness of the Clayton due diligence sampling in ar piece late last year. (See Analysis of the Shortcomings of Statistical Sampling in the Mortgage Loan Due Diligence Process.)

But watch this space for more coverage on how legal teams representing investors seek to survive threshold challenges by showing that – even if their client is or was a sophisticated investor – they may not have been privy to the types of information available to the structuring banks.

A Fair (Value) Solution

Hello readers, and a belated welcome to 2012!

In yesterday's FT Citigroup CEO Vikram Pandit advocates for heightened transparency across the banking system, enabling an apples to apples comparison that “[clears] some of the obscurity that causes people to believe the system is a game rigged against their interests.”

He is not alone. Late last year, Barclays' Group Finance Director Chris Lucas called for greater transparency in the financial reporting of liability valuations. The concept, of course, is that transparency is desired by investors, once bitten, before they can again get comfortable investing in banks.

Pandit proposes a solution that involves creating a benchmark portfolio against which banks can measure their relative risk.

Asset valuation itself has become the number one concern for the SEC in 2011: through mid-December the SEC had, according to the WSJ, issued a total of 874 “comment” letters to 802 distinct companies concerning their fair valuation and estimation of assets and contracts. Meanwhile, audit firms PwC, KPMG, Deloitte and others have been criticized as to their oversight of their clients' valuations and valuation processes (see Contested Pricing List). And so it is not surprising that banks are trying to overcome these substantial hurdles, though understandably in ways that suit them best.

The problem here is akin to the one faced by technology companies: the evaluation of their patent portfolios is no mean feat and is highly subjective – yet it is a crucial component of their stock price, especially in an acquisition or dismantling process.

Pandit’s solution is one solution. Another is more arduous, but overcomes the dual problems of inconsistency and subjectivity. It also combats the material regulatory arbitrage gaming business that has been created to minimize capital reserves. We would be able to say good-bye to a whole business of utility-free resecuritizations, structured solely to game the ratings models to achieve, or manufacture, lower reserves. It would be the end of certain Re-REMICs and perhaps even AAA-rated principal protected notes.

The solution, of course, is to evaluate each and every bond. This is already being done (to an extent) by the NAIC, and would add stability and assurance to our investor base.

Asset valuation may be more art than science, especially in the world of illiquid assets – but at least it's not a game. If well-performed, it can provide the cross-company valuation consistency even our bankers are calling for.

But it won’t be cheap.

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