A lawsuit the California Public Employees' Retirement System has filed against the three credit-rating companies should open up CalPERS, and not just the rating agencies, to scrutiny.
The suit goes to a key part of the financial crisis: Without the top ratings the agencies gave to structured investment vehicles, there would have been a smaller market for them, no unprecedented surge of investment in these instruments, no bubble in them and no subsequent crash that cost investors billions of dollars. But the overuse, reliance and dependence on them by many institutional investors brings into question whether the investors' fulfilled their own fiduciary duties.
Other pension funds and other investors should welcome the suit. The courts will have to adjudicate the merits of the case. But a trial, if the case proceeds to that point, would allow a detailed airing of how Moody's Investors Service Inc., Standard & Poor's and Fitch Ratings Ltd. determined credit ratings and the incentives tied to how they are paid for those ratings.
The case also might put CalPERS and its managers on trial, and open the nation's largest pension fund to unwelcome scrutiny and criticism. That is a good thing for CalPERS' participants and other investors.
The case involves CalPERS' $1.3 billion investment in three structured investment vehicles: Cheyne Finance LLC; Stanfield Victoria Funding LLC; and Sigma Finance Inc. All three “collapsed in 2007 and 2008, defaulting on their payment obligations to CalPERS,” costing it “perhaps more than $1 billion of investment losses,” according to the lawsuit filed July 9 in California Superior Court, San Francisco.
The $178.1 billion CalPERS makes serious charges against the companies that should be aired and argued. For example, the suit claims S&P and Moody's made three times more from scoring collateralized debt obligations than from rating traditional corporate bonds. The agencies not only rated the SIVs, but also were actively involved in their creation and had an incentive to issue high ratings, the suit states.
It charges the credit-rating companies “made negligent misrepresentations to CalPERS” and its money manager agents, causing the losses. “The credit ratings on the three SIVs ultimately proved to be wildly inaccurate” and were based on rating methods “seriously flawed and incompetently applied,” the suit states.
The case will test the protection the credit-rating firms have from legal action regarding their liability for their ratings.
In a trial, scrutiny of CalPERS should focus on its due diligence and risk management operations. Why did CalPERS, and the investment firms that managed the investments, appear to outsource risk management and credit evaluation to the three credit-rating firms? The identities of the investment managers were unavailable from CalPERS.
The lawsuit states the SIVs “were massive structured finance products” that were so “opaque” the rating agencies were the only outside entities that knew what assets a SIV actually purchased. Despite these complexities and the SIVs' illiquidity, the rating agencies gave the SIVs “their highest rating,” leading CalPERS to invest in them, and causing CalPERS “to suffer substantial investment losses,” the suit said.
The credit-rating companies, assuming the case proceeds, should welcome the opportunity to defend their methodologies and activities. A trial could give them a chance to repair damaged reputations, if they can prove their methods were appropriate and not influenced by conflicts.
In a trial, CalPERS should be questioned about why it was dependent on a rating system that appeared to be unchallengeable and unaccountable for decisions that influenced investors.
CalPERS wasn't the only pension fund or investor apparently overly reliant on credit ratings, but CalPERS is as sophisticated an institutional investor as there is.
With smart trustees and immense resources, it employs a highly regarded professional investment staff and can contract with any top-tier investment manager and consultant for advice. Surely, with its size, reputation and resources it could have obtained independent verification of the quality of the vehicles.
Or, as it seems, did they succumb to the lure of an AAA rating in an exotic instrument as a key basis for investing, apparently without the appropriate due diligence of the credit-rating evaluation process, the SIVs' underlying investments or the investment managers?
These are the kinds of questions the court case should answer, as well as the culpability of the rating agencies.