In a system based on risk and driven by profits, investors are understandably attracted to deals with the highest returns and the lowest chances of failure.  But, in a system based on risk and driven by profits, how can one trust a competitor’s product?

The role of credit rating agencies, such as Standard & Poor’s (“S&P”), is to provide a third party analysis of the risk involved in a deal and to assign it a credit rating based on the borrower’s ability to repay the applicable loans.  The safest transactions are given a triple-A credit rating, reflecting the credit agency’s finding that the debtor will certainly be able to honor his obligations.  This system has become a trusted and integral part of the global securities market.

So why, in 2007 and 2008, were deals based on largely fictional assets given the highest credit rating by S&P?  How were investors convinced to buy packages of junk wrapped with a triple-A bow?

Recently the Securities Exchange Commission (“SEC”) notified S&P that it was considering taking civil action against the agency for violation of federal securities laws.  In 2007 S&P assigned its highest rating to a $1.6 billion mortgage-bond deal that quickly imploded during the early stages of the financial crisis .  The rating was for a collateralized debt obligation called Delphinus.

Collateralized debt obligations (“CDOs”) are a type of asset-backed security that are organized into varying levels of risk depending on the assets, or debt obligations, backing them.  The “safer” the CDO means the lower the risk premium, because the debt obligations were almost certain to be paid.  In this case, those debt obligations were subprime mortgages and the housing market was teetering on the brink of collapse.

The SEC alleges that the Delphinus CDO was given a triple-A rating based on “dummy,” or hypothetical, assets.  After receiving this rating, bankers replaced these fictional assets with actual assets of a much lower quality, yet S&P allowed the CDO to maintain it’s triple-A status.  To investors this appeared to be a classic bait and switch.

This SEC investigation may lead to the first government backed legal action against the major credit rating agencies, but it is not the first lawsuit to be filed against S&P for similar misrepresentations.  S&P has previously been accused of assigning over-the-top ratings to bonds backed by subprime mortgages and of pressuring analysts to change ratings in order to get more business.  S&P allegedly worked directly with banks, such as Morgan Stanley, to help structure CDOs and were then compensated based on those notes receiving premium ratings.   This created a conflict of interest that led to grossly inflated credit ratings.

Of the lawsuits that have been filed to date, over 30 have been dismissed or dropped, as judges have ruled that the ratings were protected by the First Amendment.  The credit rating agencies argue that the risk analysis involved in a deal and the ratings they assign are only their opinions and are therefore protected by the right to free speech.  Plaintiffs have been unable to point to any evidence that S&P intentionally issued inflated ratings, that these ratings were relied upon, or that the effect was to defraud investors.

In late 2009, Judge Shira Scheindlin, of the United States District Court for the Southern District of New York, took the first step toward prosecuting these credit agencies by refusing to dismiss a class action lawsuit based on deceptive ratings and rejecting the argument that the ratings were opinions protected by First Amendment rights.  The case, King County, Washington v. IKB Deutsche Industriebank AG, includes S&P, Moody’s and Morgan Stanley as defendants.  Judge Scheindlin held that the plaintiffs had adequately stated primary causes of action for common law fraud against the rating agencies.  She goes on to say that opinions by the ratings companies may be the basis for a lawsuit if the companies do not genuinely and reasonably believe the rating assigned is appropriate or if it is without basis in fact.  Here, Judge Scheindlin found that there were enough issues of fact to withstand the motion to dismiss and the lawsuit is still an ongoing matter today.

This case in the Southern District of New York and the impending legal action by the SEC concerning S&P’s rating of the Delphinus CDO may finally lead to some accountability for the inflated ratings that helped fuel the worst financial crisis since the Great Depression.  One successful case will likely open the floodgates to charges of fraud, negligence, and breach of contract against the major credit rating agencies.  More importantly, these actions will hopefully compel regulation reforms in the monitoring of credit ratings and curb the ability of banks to deceptively market high-risk investments wrapped with a triple-A bow.