Monday, April 8, 2013

Dispelling a Myth or Two about the Ratings Lawsuits

Since the Justice Department sued S&P for fraud in February, the media has been awash with concerns as to whether a lawsuit against Moody's will inevitably follow - and questions about the lack of a lawsuit against Moody's pointing to the potential for bias on the side of the DOJ.  The inference drawn was that the DOJ might be targeting S&P because S&P downgraded the debt of the United States.

Meanwhile, market participants and researchers have honed in on the fact that other credit rating agencies issued “virtually identical” grades on the same securities that lie at the heart of the lawsuit.

Commenting on the fact that S&P alone has been sued (at this stage) by the DOJ, a member of S&P's general counsel reportedly remarked “The S&P ratings for the CDOs at issue in this lawsuit are identical to the ratings issued by other rating agencies. So we don’t have an explanation and you’ll have to ask the Department of Justice…”

Meanwhile, Edwin Groshans, a managing director, at Washington-based equity research firm Height Analytics LLC, reportedly commented that “Given that the ratings between S&P and Moody’s were identical, a loss by S&P would create significant uncertainty for Moody’s regarding whether the Department of Justice would take action against it also…”

Of course, while these arguments may have been carefully considered, and may even have some rational basis, they are built on a faulty premise.  Let us explain why. 

Straw Man Argument

The key distinction is that the DOJ is not suing for fraud in the rating provided.  The DOJ isn't saying the rating was wrong or imprecise or otherwise lacking in predictive content. Therefore, that Moody's provided the same or an equivalent rating has no import.

The DOJ is saying that in the context of these securities, it is concerned that S&P maneuvered its ratings process, in a manner neither objective nor unbiased, to achieve a necessary result (including the generation or maintenance of revenues).  As such, if Moody's already had achieved THAT result based on its then-current methodology, it would not have had to maneuver towards it.  No foul committed.

In the case of active ratings competition, it is often (but not always) the case that any jockeying done is done (or needs to be done) by the more severe rating agency/agencies, so as to allow them to compete with other raters who have a rosier view. 

An Example

Suppose we have a world with only 3 rating agencies – Moody's, Fitch and S&P – with two being selected to rate each bond.  If for example Moody's and Fitch were the two raters getting business because their methodologies resulted in the highest rating, S&P alone would have an incentive to maneuver so as to win new business or disrupt status quo.  If they did, and their actions resulted in their achieving the same view as say Moody's, then they may be included on certain deals.  But how does this translate into any misdemeanor on the side of Moody's?

Is S&P is being subjected to special attention, or targeted?  We don't know.  But it has nothing whatever to do with the nature of the lawsuit that, because Moody's may have rated the assets at similar levels, it ought similarly to be accused of improper conduct.

That Moody's achieved a similar rating to S&P does not imply that its ratings process was influenced in a manner similar to that described by the DOJ in its lawsuit against S&P.

It may be the case that in certain scenarios all 3 rating agencies simultaneously, knowingly, intentionally, lowered their ratings standards to compete for the same business, while advertising themselves as being independent investor services.  This is possible - but until that is known to have occurred, any argument suggesting Moody's ought to be similarly defensive to any charges alleged of S&P is, to us, simply an informal fallacy