Should ratings agencies be responsible for getting it wrong?

Should ratings agencies be responsible for getting it wrong?

One of the world’s largest ratings agency, Standard & Poor’s, is back in court appealing the Federal Court’s landmark decision that it was responsible for the losses incurred by 13 New South Wales councils.

The local councils made losses on investments in complex instruments that had S&P’s coveted AAA rating. But the company told the ABC it was “not responsible for investment decisions and investors need to do their own analysis”.

In this Viewpoints, Binoy Kampmark argues investors should know ratings aren’t guarantees on risk; while Gail Pearson makes the case that investors expect the ratings to have a reasonable basis.

Binoy Kampmark

The question here is one of accountability, and what generates it. These are both ethical and legal questions. Credit rating agencies pride themselves on setting measurements about the financial health of assets, and more broadly, of a financial system.

These can have considerable economic impacts, none of which directly affect the ratings agency in question.

During the global financial crisis it became clear that these financial assessments were made without oversight. But is relying on these assessments without due diligence irresponsible in its own right?

It was clear that the credit mechanism being used in this case – the Constant Proportion Debt Obligation notes (CPDOs) – was unstable. Even economists at the US Federal Reserve admitted as much.

That these local councils were relying on just these assessments as statements of fact rather than assertions of opinion should itself be a cause for concern.

Gail Pearson

The issue of the reliance of the local councils is very important. But what were they relying on? They were relying on the expertise of their investment adviser – who was not the ratings agency – and they were also relying on the AAA rating given by the ratings agency.

I’m not sure about Binoy’s distinction between opinion and fact. The local councils knew there was risk in investing. They knew that there was a potential for loss. So they were relying on an assessment by the ratings agencies about the nature of that risk.

Part of the question is whether they were in a position to assess the risk of these very complex products for themselves. They weren’t.

It seems there was nothing in the documentation they received that indicated the extent of the risk. Assessment of investment risk is highly complex and technical. This is why investors rely on ratings agencies.

In any case, the distinction between fact and opinion is not very helpful to those who provide opinions that are not based on reasonable grounds.

We have, in Australia, a very well developed jurisprudence around the prohibition on conduct that is misleading or deceptive or likely to mislead or deceive. This prohibition exists in a number of pieces of legislation.

You fail to live up to this norm of conduct if you express an opinion without reasonable grounds for that opinion. If investors rely on the opinion of those who provide investment advice or those who grade an investment product, they are entitled to assume that the persons providing that opinion have a reasonable basis for what they are saying.

So the question comes back to whether ratings agencies, when they provide a particular rating, have a reasonable basis for saying that it has three gold stars or none.

It is not unlike ratings given in other contexts – think hats for restaurants or stars on travel websites. There must be a reasonable basis for the opinion. That was the issue here.

Story continues on page 2. Please click below.


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