For those keen to cast blame for the subprime meltdown, the rating agencies have already emerged as a favored target. For example, when Citigroup recently announced (here) a significantly increased write-down of subprime mortgage assets, it attributed the action to recent rating agency asset downgrades.

The rating agencies’ own shareholders have already jumped on the blame game bandwagon, suing Moody’s (refer here and here) and S & P’s parent company, McGraw-Hill (refer here), alleging that the agencies assigned excessively high ratings to bonds backed by risky subprime mortgages – including bonds packaged as CDOs – causing investors to be misled as to the quality and riskiness of these investments. (My earlier post on the lawsuits against the rating agencies can be found here.)

Connecticut Attorney General Richard Blumenthal has even announced (here) that he has issued subpoenas to the three largest rating agencies as part of an antitrust investigation into the debt rating industry.

In addition, academics have, as discussed at greater length here, already questioned whether investors in mortgage-backed assets may try to target rating agencies, alleging that they (the investors) were misled into investing in assets on the mistaken belief that they were investing in investment-grade assets. Investors, the academics theorize, might allege that the rating agencies’ conflicts of interest and involvement in the deal process led to the agencies’ understatement of risk.

One possible constraint on claims of this sort may be that in the past when rating agencies have been sued (for example, in connection with the Orange County bond default), the agencies have successfully argued that their rating activities were protected by the First Amendment, as mere opinions of creditworthiness.

In a November 2007 paper entitled "Not ‘The World’s Shortest Editorial’: Why the First Amendment Does Not Shield the Rating Agencies From Liability for Over-Rating CDOs" (here), David Grais and Kostas Katsiris of the Grais & Ellsworth law firm take the position that "the First Amendment will not protect the rating agencies in the massive litigation likely to ensue from their role in the subprime debacle."

The authors concede that rating agencies are indeed entitled to First Amendment protection when they are "acting as a member of the press," as for example when they are publishing indicies, databases or periodicals. The authors contend that a different standard applies when the rating agencies are rating a security; in particular, they contend that the courts have found that rating agencies are not entitled to the First Amendment protection when three factors are present: when a rating agency "rates only those securities it is hired to rate"; when the rating agency "participated in structuring the security"; and if the security was "privately placed" rather than "offered to the public."

These factors, the authors argue, weigh against the rating agencies in connection with any attempts to rely on the First Amendment to protect their activities in rating CDOs. The authors contend:


In their traditional role of rating and writing for their subscribers about all debt securities offered and traded publicly, the rating agencies may well have acted as members of the press. But in rating structured securities like CDOs, which the agencies normally rate only for a fee, often participate in the structuring of, and which are usually sold and traded privately, the reverse is true: the rating agencies are not journalists gathering information and reporting to the public, but rather participants in the transactions that they rate.

The authors go on to argue that, even if the agencies activities are found to fall within the First Amendment’s protection, the protection afforded would not be sufficient to shield the agencies from liability, since the rating agencies would still have to show why they should be exempt from "laws of general application" (such as tort law provisions for negligence or fraud, for example). The authors argue that the rating agencies would not be able to rely on either of the usual bases on which such exemption is claimed. That is, the rating agencies will not, the authors contend, be able to rely on the usual defenses of the absence of "actual malice" or that their ratings were protected "opinion." Therefore, the authors contend, neither of these theories "will help the rating agencies in litigation for over-rating CDOs and similar securities."

The rating agencies are well aware that they face these kinds of criticisms and attacks and have already begun marshalling their defenses. For example, in an August 23, 2007 publication entitled "The Fundamentals of Structured Finance Ratings" (here), S & P set out to answer its critics and defend its structured finance practices. The publication defends the dialog that occurs during the process of rating structured finance products, such as CDOs, saying that it is no different than the routine discussions involved in non-structured finance-related issues, and an in any event does not amount to "advisory" work; the publication asserts that "we will never tell an arranger what it should or should not do."

And as for the fact that the rating agencies are paid by the issuers they rate, the S & P publication asserts that its ratings are "extremely transparent" because all ratings are published and all transactions are described in press and industry reports. "Any untoward behavior," the publication notes, "would attract instant attention and endanger both investor confidence in us and our entire franchise." The issuer-pay fee mechanism also allows S & P to publish ratings free to investors, promoting the "broad and free dissemination of important information to the marketplace quickly."

While the legal article’s authors recognized the S & P publication as "thoughtful," the legal article’s authors also contend that the S & P’s points "are unlikely to persuade the courts that S & P or its competitors act as members of the press when they rate CDOs." The role that the rating agencies play may not be an advisory one, but their participation in the structuring of the security by their commentary on the various iterations may be enough to establish a role that is incompatible with the invocation the full First Amendment protections.

Whether or not the legal article’s authors’ analysis ultimately proves correct, their theories are likely to receive an attentive hearing in certain quarters, and their views are likely to strengthen the already established tendency to assign blame to the rating agencies for the subprime meltdown. Given the authors’ analysis, it seems probable that the subprime litigation wave will include mortgage-backed asset investors blaming their losses on rating agencies for investments they contend were inappropriately rated as investment-grade.

Special thanks to Kostas Katsiris for providing a copy of and a link to the legal article.

$400 Billion in Subprime Losses?: Whatever incentives there are now for blame shifting against the rating agencies are only likely to increase in the coming months, as mortgage related investment losses grow. While estimates of the likely losses from the subprime meltdown are necessarily imprecise, some of the estimates are nonetheless impressive. For example, according to a November 12, 2007 article (here), a Deutsche Bank analyst has estimated that "losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide."

The Deutsche Bank analyst specifically projects that Wall Street banks and brokers ultimately may be forced to write down as much as $130 billion due to the decline in subprime debt, up to $60 or $70 billion of that this year. (Current write-downs total around $40 billion).

Losses anywhere near that order of magnitude will definitely provoke the investors and others to look for targets against whom to assign blame. I suspect strongly that before all is said and done, the First Amendment theories discussed above will be fully ventilated in the courts.

Rule 144A Markets Form Single Trading Platform: As I have previously noted, various parties have recently launched competing platforms for trading Rule 144A securities. For example, Goldman Sachs launched it s GSTrUE platform (as discussed here), several other investment banks had combined to form the OPUS 5 platform (refer here), and NASDAQ had lauched the Portal platform (refer here).

However, on November 12, 2007, Nasdaq announced (here) that the leading Wall Street firms had dropped their competing systems and agreed to cooperate on a single platform, the Nasdaq Portal system. The founding members include Bank of America, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley , Nasdaq, UBS and Wachovia Securities.

Nasdaq said about this intitiative that:


The PORTAL Alliance will work with third-party service providers to create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs").

The PORTAL Alliance participants will contribute the expertise gained in connection with the development of their existing 144A platforms to create an industry standard facility with a uniform set of procedures for issuers and QIBs to bring greater efficiency and transparency to the 144A equity marketplace.

A September 12, 2007 Wall Street Journal article discussing the formation of the single platform alliance can be found here.