Opening Cross: More Cause for Optimism in 2013—Unless You’re a Ratings Agency

Within the past week, the Dow Jones Industrial Average broke 14,000 points for the first time since October 2007 and exchanges reported record financial results, giving added credence to the optimism expressed by many for 2013.

For example, CBOE Holdings reported revenues of $512.338 million for 2012 last week—$24.36 million of which was revenues from market data, up 22 percent from $19.906 million in 2011—while IntercontinentalExchange reported record revenues and net income for 2012 of $1.36 billion and $552 million, respectively, with market data revenues rising 17 percent to $142 million.

In contrast, revenues at ICE’s takeover target NYSE Euronext fell by 18 percent to $3.749 billion for 2012, with market data revenues also falling from $371 million to $348 million for the year. So NYSE will undoubtedly be glad to see the back of 2012—and with new management in place at NYSE Technologies in the form of former Thomson Reuters execs Jon Robson and Terry Roche (IMD, Sept. 11, 2012; Jan. 15), management will be expecting a reversal of fortune in 2013.

However, Standard & Poor’s Rating Services may already be missing 2012, after the US Department of Justice filed a civil lawsuit against the rating agency last week, alleging that it deliberately misled institutional investors about its independence and knowingly issued inflated ratings for residential mortgage-backed securities and collateralized debt obligations in the run-up to the 2007 credit crisis.

The suit alleges that “S&P reaped record profits by issuing and/or confirming CDO credit ratings that S&P knew did not accurately reflect the credit risks of those CDOs because they failed to account for the substantially increased credit risks posed by certain non-prime RMBS tranches that backed those CDOs.”

In effect, it says, S&P spent more time worrying about competing for deals against Moody’s and Fitch than it did on ensuring its products accurately reflected the risk of RMBS and CDOs, and that those concerned about S&P’s actions were “prevented by… S&P executives from downgrading the ratings of subprime RMBS because of concern that S&P’s ratings business would be affected.” The problem, it appears, is not that S&P made mistakes, but rather that it knowingly allowed itself to continue making them. For example, by 2002 S&P owned a dataset of 642,000 residential mortgages originated between 1971 and 2001, including riskier loans, but did not start using this data until sometime in 2004, and never released a planned more accurate analytical model for rating RMBS. After noting that this would underprice risk, one exec was told that “if… [the upgrade] was not going to result in S&P increasing its market share or gaining more revenue, there was no reason to spend money putting it in place,” according to the DOJ.

S&P officials have dismissed the suit as “meritless,” and—while acknowledging that “S&P, like everyone else, did not predict the speed and severity of the oncoming crisis”—point out that the vendor has since invested $400 million to strengthen its ratings, that other rating agencies also issued the same ratings, and that S&P took remedial ratings actions before rival agencies (though the DOJ has not yet leveled charges against other agencies, and Fitch says it has no reason to believe it is the target of any similar action).

Whether the failings were institutional or the result of individuals’ actions, the DOJ case presents enough evidence—collected from more than a million documents and over 150 interviews—to impress on any provider of proprietary information the need to ensure it can meet its claims, especially when so much money relies on them. After all, if you buy a slab of meat certified as organic beef and discover it to be factory-farmed (or worse, horse), you would be entitled to your money back. Should S&P or others have to refund firms’ money—in addition to any fines resulting from lawsuits—earlier decisions to protect revenues could prove very costly indeed.