And whether they like it or not, the government has treated the rating agencies as de facto regulators for 75 years. Beginning in 1936 the Fed and the FDIC announced that banks were prohibited from holding "speculative securities," which were those without a rating of triple-B or higher. In 1951, the National Association of Insurance Commissioners imposed higher capital reserve requirements for lower-rated bonds. In 1975, the SEC mandated that broker/dealers should apply higher capital haircuts on bonds rated below triple-B. In 1989, in the midst of the savings and loan crisis and the collapse of the junk bond market, Congress passed a new law prohibiting S&Ls from investing in bonds rated below triple-B. In 1991, a new rule by the SEC limited the amount of lower-rated paper that could be held by money market funds.
This stuff is all very obvious to anyone from the financial world, who would know that ratings determine the price and availability of credit.
A Credit Rating Cannot Be Separated From a Structured Finance Deal
S&P's First Amendment defense, as it pertains to ratings for structured finance deals, relies on a warped definition of the word, "opinion." An opinion is something entirely separate from the object of that opinion.
That's the way it is for ratings assigned to any company or entity other than a structured finance transaction. Microsoft, Spain, Enron and Stockton, California all existed in some form or other prior to the point when they received credit ratings. The rating agencies played no role in the "creation" of any of these entities.
But structured finance transactions are creatures of the law. They have no existence before they close, and they cannot close until all conditions precedent have been attained. And invariably, one of those conditions is that certain specific ratings from certain rating agencies will be assigned to specific tranches of the deal.
Rating agency standards are legally embedded within every structured finance deal, the way a father's DNA is embedded in a newborn child. It's absurd to argue otherwise. Which is why any court decision pertaining to a credit rating for a non-structured finance deal would be totally irrelevant to the cases before a number of State and Federal Courts.
What About Those Court "Precedents"?
In its effort to prevent the filing of a lawsuit in South Carolina, S&P cites two Federal Court decisions, Jefferson County School District v. Moody's, and Compuware v. Moody's. Neither case addressed the issues pertaining to the recently filed lawsuits pertaining to mortgage securities and CDOs.
In Jefferson County, Moody's was sued for defamation, based on the rating agency's announcement of a "Negative Outlook" for certain bonds. The Tenth Circuit ruled that the phrase "Negative Outlook" was too vague to constitute an actionable claim of defamation.
By way of contrast, a triple-A rating assigned to a bond is not vague at all. It is a clear cut statement that the risk of loss within a three or four-year period is submicroscopic. The rating agencies specifically quantify the risk of default and loss according to credit ratings, and they use those numbers to quantify the risk of loss on bond portfolios, like CDOs.
At first blush, Compuware seems more relevant. Compuware sued Moody's after the rating agency downgraded the firm, which had no funded debt, from Baa2 to Ba1. Compuware accused Moody's of making defamatory statements, whereas Moody's said it was making a subjective evaluation about the firm's longterm business prospects. That was good enough for the Sixth Circuit, which wrote:
A Moody's credit rating is a predictive opinion, dependent on a subjective and discretionary weighing of complex factors. We find no basis upon which we could conclude that the credit rating itself communicates any provably false factual connotation. Even if we could draw any fact-based inferences from this rating, such inferences could not be proven false because of the inherently subjective nature of Moody's ratings calculation.Yes, predictions are hard, especially about the future. It's one thing to draw inferences regarding the future of a high tech firm, quite another to draw inferences from a mountain of statistics pertaining to mortgage defaults.
S&P is licensed as Nationally Recognized Statistical Rating Organization. It cannot simply ignore history and statistics--any more than a doctor can ignore history and statistics about the effects of smoking--when it assigns credit ratings.
Yet that's exactly what the rating agencies did when they assigned triple-A ratings to mortgage bonds and CDOs. They simply disregarded the statistics concerning real estate cycles, hyper-leveraged transactions, default correlations and the incidence of mortgage fraud. Again, triple-A ratings on mezzanine CDOs were no less reckless than Henry Blodget's "buy" ratings.
Which is why the case against the rating agencies is a slam dunk.
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