The Justice Department's accusations of fraud against Standard & Poor's Financial Services LLC in issuing credit ratings on mortgage-related securities should draw attention to the investment practices of pension funds and other institutional investors that invested billions of dollars in the securities, lured by their supposedly high creditworthiness.
The case, which focuses on the credit rating of collateralized debt obligations and residential mortgage-backed securities, provides a framework for pension fund executives and trustees and other institutional investors to examine their policies and practices, including due diligence and risk management, to uncover and correct deficiencies.
In the runup to the financial crisis of 2008, collateralized debt obligations and residential mortgage-backed securities were relatively new and complex financial instruments, created by financial engineers. That should have prompted fiduciaries and investment managers to treat them differently, to give credit ratings more scrutiny, compared with traditional corporate bond and other debt securities.
The Justice Department case goes to the heart to the financial market crisis. The alleged misrating of the CDOs and RMBS helped balloon housing prices and boost investment in mortgage-related securities.
Such action “is believed to have contributed to the worst economic crisis in recent history,” U. S. Attorney General Eric Holder said in a statement following the Justice Department's filing of its complaint Feb. 4 in U.S. District Court in Los Angeles against S&P and its parent, McGraw-Hill Cos.
Among its accusations, the Justice Department charges S&P did not adhere to its own credit-rating standards in rating CDOs and other complex investment vehicles.
The question for pension fund fiduciaries and other institutional investors is whether their losses from these types of securities could have been mitigated or avoided, with better policies and procedures for examining them.
For policymakers, the case also should shed light on the federal government's complicit role in enabling the major credit-rating firms to become the entrenched gatekeepers of the financial markets. That role includes the Securities and Exchange Commission designating major credit-rating firms as nationally recognized statistical rating organizations and embedding credit-ratings in standards for certain investment vehicles.
For example, federal statutes and regulations “required certain financial institutions to hold only securities with credit ratings that qualified them as "investment grade'.... As a result, financial institutions, including some that were required to do so by law, relied on credit ratings issued by NRSROs,” including S&P, the suit states.
S&P and other credit-rating agencies stepped in to provide reliable ways to assess creditworthiness of RMBS and “enabled conservative investors, such as pension funds ... to gauge the risk of the structured finance investments without tying up valuable resources by having to analyze the underlying assets themselves,” according to a 2007 S&P observation cited in the complaint.
Pension funds and other institutional investors were under no requirement to follow the credit ratings exclusively. But an apparent overreliance on credit ratings led many institutional investors to invest in the securities. A chance to free resources for other purposes might have motivated institutional investors to accept credit ratings in forming portfolios.
But a AAA rating cannot replace investor due diligence.
Problems with the NRSRO designation predate the financial market crisis and were foreseen by some.
The Sarbanes-Oxley Act of 2002 required the SEC to re-examine the NRSRO role. But in 2006, Frank Partnoy, professor of law at the University of San Diego, testified before a Senate committee, noting the SEC, which created the designation, “did not even attempt to define "NRSRO' until recently, 30 years after it first used the term.” In his testimony, he said, “It is no coincidence that NRSRO ratings played a central role in the bankruptcy of Orange County (Calif.), the collapse of Enron and numerous other scandals.”
The many AAA or top ratings S&P and other credit-rating firm issued for the securities should have raised red flags, calling forth more scrutiny of the issues. Even in Lake Wobegon, all the children are only above average, not scoring AAA ratings.
From September 2004 through October 2007, S&P alone issued credit ratings on more than $2.8 trillion of RMBS and $1.2 trillion of CDOs, according to the complaint.
The case, and losses generally caused by structured investment vehicles, show that sophisticated investors sometimes don't fully understand the risks of particular investments, or comprehend mounting risks that threaten the financial system.
There were other reasons to raise red flags that should have led to greater analysis. These included a lack of transparency of the securities, whether because of an issuer's proprietary process for assembling the debt into a collateralized pool, or because of conflicts of interest in the rating process.
One of the allegations in the complaint is that conflicts of interest influenced S&P's credit ratings and practices. In fear of losing market share and profit in the business, S&P weakened analytical models and ratings criteria its own analysts believed to be essential for better accuracy, according to the complaint. Adding to conflicts was how the ratings were actually paid for. “Although S&P typically was retained by — and charged its fees to — CDO issuers ... those issuers ordinarily did not bear the cost of the CDO ratings fees,” the complaint states. “Instead, as S&P knew, the costs of those fees were passed through to investors who purchased CDO tranches.”
Investors were aware of this model. In fact, at a meeting of the S&P's structured finance investor council —a group of institutional investor representatives with which S&P periodically consulted to discuss issues related to such investments — one participant advised: “Investors need to publicly voice their opinions on issues like the issuer pay model; investors ultimately do pay” fees out of total deal proceeds, according to the complaint.
Pension fund fiduciaries and other institutional investors should question how they apply their own policies and practices in dealing with potential conflicts with investment-related providers. The questionnaires pension funds send out in requests for proposals in searches for consultants or investment advisers often ask the sources of compensation and conflicts, enabling fund executives to evaluate any impact. That scrutiny should apply to all types of providers, even credit-rating firms.
Institutional investors need to step up and strengthen their due diligence and risk management to avoid allocations to investments where potential conflicts and lack of transparency prevail. They need to verify the risk levels of their potential investments or stay away from them. Such action might have avoided damaging losses stemming from the financial market crisis. n
