“The issuer-pays model is fraught with conflicts,” said Connecticut Attorney General Richard Blumenthal, appearing on CNBC Wednesday [March 10].

Earlier in the day, Blumenthal, invoking a state unfair practices law, The Unfair Trade Practices Act, filed a civil suit in Hartford Superior Court against the two largest rating agencies, Moody’s Investors Service and Standard & Poor’s. The Connecticut AG’s suit claims that Moody’s and S&P deliberately, misleadingly, slapped favorable ratings on dicey structured products in an effort to maintain favor with bank issuers buttering their bread.

Asked by CNBC’s Erin Burnett about damages being sought, Blumenthal didn’t bite. He declined to throw out any big scary numbers on live television, what with most of the stock market watching him, although he did tell The Hartford Courant that the figures possibly could reach into the hundreds of millions of dollars.

Blumenthal, at least in the CNBC segment, appeared less concerned about recouping dollars from Moody’s and McGraw-Hill, and more intent on shaming the agencies under the auspices of reforming their practices in the spirit of consumer protection. And while fixed-income portfolio managers and trustees of public pension funds deserve the same fundamental rights as guzzlers of scalding hot McDonald’s coffee, it remains to be seen whether public outrage over shady Wall Street practices has enough fervor left to go around later in the year when it comes time to make more hay with faulty ratings given to complex securities backed by various forms of loans and revenue streams. Will the public, or a jury for that matter, have much tolerance for any narrative in which the central character is a AAA-rated ABS CDO vehicle issuing debt and equity, then investing the proceeds in various forms of securities, including but not limited to RMBS Alt-A….

Perhaps Blumenthal is looking to strike a blow on behalf of Connecticut-based hedge funds—among the foremost consumers of the research coming from Nationally Recognized Securities Rating Organizations and which Blumenthal believes to be so odious. I have yet to see any partners of a folded hedge fund seek reparations from raters.

Blumenthal sued the rating agencies separately, last summer, claiming that they were giving out better ratings to Wall Street wares and weaker ones for municipal issues in a sort of two-tiered system.

So for those keeping score, Blumenthal has sued rating agencies because some ratings are too low now, and also because others were too high then.

Congress is in the midst of a massive financial reform steel cage match. When the grab bag of proposals get sorted out, it could be, under one possible legislative scenario, easier for investors to sue rating agencies. This liability question already looms large over the entire industry. Rating agencies, after all, are already getting sued, left, right and center.

One major Lehman-related lawsuit filed by two pension funds against the big rating agencies was dismissed in late January by Southern District New York State Judge Lewis Kaplan who said that under the Securities Act of 1933 the agencies were not liable; they weren’t the issuers. If Consumer Reports or Kelley’s Blue Book ever gave Toyota a good safety shout out in past years, would anyone think to file suit against them?

CalPERS is currently suing the rating agencies—it’s a case involving SIVs. Banks sold CalPERS instruments tied to off-balance sheet financings. CalPERS is blaming the rating agencies now that they have been burned.

(”Sure, I like my coffee hot your honor but I didn’t expect it to burn my lips off!”)

The SEC is in the midst of rewriting rules that require ratings in the first place, but only for some types of securities. After the infamous Penn Central debacle in the early 1970s the SEC required credit issues to be rated, thus giving birth to a humongous industry.

Interestingly, today, money market funds kicked and screamed over the possibility that ratings would no longer be required as part of their investment mandates; they did not want the ratings requirement removed from the rule books likely because when they screwed up and bought something that went sour they could still have someone to blame.

Even as they reconsider rating requirements, the SEC is also, rightfully, going after the practice of ratings shopping.

Among the many fairly standard but no less dubious Wall Street practices, which in hindsight seem particularly unscrupulous, was banks awarding ratings gigs to the agencies who handed out the most favorable ratings to their structured products. On a corporate bond or a muni, rating agencies all have access to the most of the same cash flow and balance sheet info. But for a structured, securitized product, such as an ABS tied to a stream of credit card receivables, well that’s bespoke, private, the issuers have that info and it’s all unique to the deals they are selling.

To prevent ratings shopping from ever happening again, the SEC wants to make all the data points that go into the creation of a rating available to any NRSRO who wants it, so as to have the fixins’ to come out with their own unsolicited rating. In effect the SEC is fostering a “second opinion” market in the credit rating realm.

If this data is centralized, accessible, and second opinions can be issued, perhaps Moody’s or S&P can come out with better, more accurate, must-read assessments of downside risk. Maybe these unsolicited ratings will spawn new spread-bet markets or attract a loyal fan base, even earn the agencies some investor-pay model fees flowing from various money managers and stewards of retirement funds who by the way surely never solely relied on a rating to provide them creditworthiness assurances in much the same way that the parents of a ten-year-old boy wading into rough Montauk surf wouldn’t solely rely on the lifeguard back on the beach to prevent their frolicking lad from getting sucked out to sea.

Some niche rating agencies could in theory take all the second opinion data (which is supposedly to be made digitally available on an issuer-sponsored website) and bust out their own more skeptical ratings of an ABS CDO causing the market to reconsider the issuer-paid ratings, so fraught with conflict, as Blumenthal pointed out.

More likely, the niche agencies won’t bother because they won’t be getting paid for unsolicited ratings.

Maybe there will no longer be rating agencies because the regulatory crackdown, political blowback, legal bills and damage awards will in the end crush them. At that point every money manager and pension fund would be on their own with no one to blame but themselves when, seduced by the charms of higher than treasury yields and some slick team of salespeople, they get their lips burned off.

This entry was posted on Thursday, March 11th, 2010 at 10:55 am and is filed under The Offering. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.