The attempt by prosecutors in the Italian town of Trani (population: 53,000) to take five Standard & Poor’s executives and two from Fitch to court for market manipulation is the latest bizarre twist in Europe’s tortured struggle to come to terms with the role of rating agencies in the financial crisis.
Courts in Milan and Rome have refused to take on the suit, but under the Italian system, the court in this seaside town has the right to try the case, whatever metropolitan judges think of its merits.
The allegations centre on statements supposedly made by S&P and Fitch and their staff around the downgrades of Italy’s sovereign ratings since 2011. Both agencies say the suit is completely baseless.
While one should not prejudge a legal case and anything is possible, it seems unlikely that the rating agencies’ straight-laced execs put a foot wrong in communicating about this very sensitive subject — still less that they stood to gain anything by it, without which a charge of market manipulation can have little meaning.
Even the cause of the underlying grievance — that S&P and Fitch provoked volatility in Italian financial markets that led to losses for investors — seems misguided. Tradable securities are inherently and permanently volatile, for a host of reasons. Any losses on Italian markets as a result of improper communication would have been temporary.
Worse may be to come
And yet, this suit is not an isolated freak. A stream of cases is being brought against the rating agencies for a variety of perceived failings that have come to light during the financial crisis.
Last week, EuroWeek commented on an Australian court’s ruling that S&P and ABN Amro were financially liable for being misleading and deceptive over two highly complex and flimsy CPDO structures sold in 2006.
Standard & Poor’s is appealing, but the 1,500 page judgement certainly showed the agency’s boom-time structured credit processes in a bad light, with ABN bankers bullying S&P officials to interpret data the way they wanted.
The backlash against the agencies’ softness in rating investment banks’ dodgier securitisations has been intensified by rage — especially in southern Europe — at their harshness in downgrading sovereigns.
Not only is this anger sparking lawsuits, justified or otherwise. It has also produced a wave of regulation — in Europe, two waves — intended to control rating agencies and somehow make them better.
The latest of these, Credit Rating Agencies Regulation III, is grinding its way through the EU legislative process. Possible outcomes are a rule that companies must rotate their rating agencies every few years and a lower burden of proof for disgruntled market participants who complain that the rating agencies have breached Byzantine compliance rules.
Of course, genuine abuses and grievous dereliction of duty — perhaps including those around the CPDOs revealed by the Australian case — should be investigated and if necessary, people and organisations punished.
Mindless labour
But as a whole, the swathe of suits and regulations form a depressing panorama of pointlessness. They stem from a complete failure to understand the role and purpose of credit ratings.
Ratings are not handed down from heaven by an omniscient deity. They are a service to private investors, provided by independent private companies, to the best of their human ability. These firms’ continued profitability relies on investors continuing to trust their judgment.
In its pure form, that activity should not need regulating. Agencies have a keen incentive to rate securities accurately and respond to investors’ needs. If they get it wrong, it should be tough luck for the investors. If investors place too much trust in ratings, more fool them.
Yes, any company is liable if it is guilty of professional negligence. But it is obvious that when a company’s business is giving opinions, there must be some limitation of liability or the rater will not have the courage to exercise its judgment freely. In the same way, fund managers are not normally sued if, in good faith, they pick bad shares.
Trying to squash rating activity into a regulatory cage full of mind-numbingly tedious and unnecessary compliance hoops is only likely to impair the accuracy and value of ratings. So is browbeating the agencies with lawsuits.
Speak up
In the next few years, regulation and litigation pose serious threats to the credit rating industry as we know it — and that should worry investors, for whom they provide a very valuable service.
It is not too late for investors and corporate borrowers to speak up and lobby for a saner dispensation.
But any new regime for rating agencies should address the two great weaknesses of the current system, which have led directly to the present chaos of outsiders trying to interfere in and micro-manage the agencies.
One is the agencies taking money from issuers — a glaring conflict of interest. The other is embedding ratings in the regulatory framework for banks and other financial firms — something even the rating agencies don’t want. Cure those ills and set the rating agencies free.