In the firing line?
Now that dust is beginning to settle
after the banking crisis, it’s not surprising that the net is being
cast around for someone to blame, writes Mark Hunt, a Partner in
BDO's Forensic team.
Most agree that banks and bankers bear a large share of the responsibility, for leveraging their capital to perilous levels and creating incomprehensible financial products. Many blame the Regulators for not putting the brakes on the financial institutions who super-heated the financial sector. Some blame hedge funds for the destabilising consequences of shorting strategies which encouraged the growth of ‘casino’ products. Some blame fund managers for not spotting the sub-prime asset backed mortgage bubble sooner, and some blame investors for following the herd as they chased their rainbows.
To a degree, all these have both critics and apologists. But the organisations which are attracting almost universal condemnation are the credit rating agencies (CRAs). Not surprisingly, the shout is: “They must be responsible! Sue!” There is little argument that the CRAs assigned inappropriately high ratings to structured financial products when the signs were out there that the sub-prime lending industry was overheating. There seems little doubt that they continued to do this despite the mounting evidence that these products were at best unstable, at worst possibly worthless.
Why?
Well, firstly, they never properly understood the risks around the underlying securities because complexity moved quicker than their ability to keep up. Secondly they were being paid by the very same financial institutions who originated the products in the first place. In a highly competitive sector, the CRAs needed to keep what had become a vital source of income. The risk of breaking ranks and being the first prophet of doom was too great.
But one reason may not yet have been properly debated. Almost all authorities agree that they way the CRAs structured their businesses made it very unlikely they could be sued by investors for professional negligence. Did this make them more cavalier in their approach? It has proved very difficult to establish that they had a duty of care to investors with whom they had no contract (or contact). To compound matters, the CR market has few players, all of whom were using flawed valuation models; establishing negligence has therefore proved difficult given that they were all using the same basis to fail to assess risk appropriately. The CRAs are only one element of the risk assessment process, and the agencies claim that it was naïve to rely on their judgement alone (particularly in sophisticated investment institutions). Finally, who can establish proof of loss? The financial system may well have collapsed notwithstanding the CRAs’ involvement.
This all puts CRAs in a secure position as far as the risk of professional negligence claims is concerned. The actions which have begun haven’t gone very far and history says they will struggle to succeed (as was proved in the wake of the Enron collapse).
The solution will be reform. The EU issued a Public Consultation paper in December 2010, seeking views of market participants on:
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• Reducing the over-reliance on external ratings in investment decisions
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• Improving transparency and monitoring of sovereign debt ratings
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• Enhancing competition in the ratings market
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• Introducing a civil liability regime for CRAs
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• Reducing the conflict of interest inherent in the “issuer pays” model
If this succeeds in making the CRAs more accountable and subject to potential civil liabilities we can expect to see a new area of professional negligence emerge. History tells us that this isn’t the first time the CRAs have got it wrong, and it won’t be the last.
