S&P, Moody's May Lose Subprime Mortgage-Bond Suits (Update3)

Bloomberg.com: News - May 2007

by Jody Shenn

May 7 (Bloomberg) -- Moody's Investors Service, Standard & Poor's and Fitch Ratings may be successfully sued by investors who lose money on subprime-mortgage bonds and similar securities that the firms have rated, a study released last week said.

With "structured-finance'' bonds, the New York-based ratings services have moved past offering opinions on risk and essentially taken on underwriting roles, according to the paper by Joshua Rosner, a managing director of Graham Fisher & Co., an investment research firm in New York, and Joseph Mason, an associate finance professor at Drexel University in Philadelphia.

The firms have said in past lawsuits, including ones filed after the collapse of Enron Corp. and the default of Orange County, California, that their credit assessments represent views protected by the First Amendment of the U.S. Constitution. That argument has seldom failed, according to a 2005 paper by Frank Partnoy, a law professor at the University of San Diego.

Compared with corporate or municipal debt, ratings offered on bonds backed by assets leave greater "reason to question whether'' the firms "should be viewed as editorializing or advertising,'' Rosner and Mason wrote in a draft of their paper presented May 3 at the Hudson Institute in Washington.

Bond Losses

Bond investors will probably suffer about $100 billion in losses from defaults on the more than $10 trillion in U.S. home loans outstanding, Citigroup Inc. analysts led by Rahul Parulekar in New York wrote in a March 9 report. The analysts were gauging the fall-out from a doubling in delinquencies since mid-2005 on subprime and "Alt A'' mortgages packaged into securities.

Rosner said in an interview today he isn't "claiming to be a lawyer'' and he isn't sure if any lawsuits will result in damages. The point, he said, is that the rating services' First Amendment claims might not be used as easily to fight off cases.

Ratings firms last year broke with their past practices to reconsider their initial assessments on the bonds within a year, as early borrower trouble on home loans for consumers with poor credit or certain other attributes that represent higher default risks exceeded expectations. S&P cut ratings on a record 253 bonds backed by U.S. mortgages in the first quarter.

Worked for Medley

Rosner is a former analyst at Medley Global Advisors, the consulting firm founded by Richard Medley, former chief political strategist at Soros Fund Management. Mason is a visiting scholar at the Federal Deposit Insurance Corp. and senior fellow at the University of Pennsylvania's Wharton School of Business.

Rating services, which get paid by issuers for assessments, may lose in court because they've guided bond sellers on how deals should look by making their models available and offering "pre-rating feedback,'' Rosner and Mason wrote. The firms also help guide the legal features of the transactions, while sometimes relying on the same lawyers as issuers, they say.

Also unlike with corporate debt, the complexity of mortgage and other structured-finance bonds means credit ratings are a "necessary'' part of being able to sell the securities, which makes ratings firms more likely to be deemed part of the underwriting team, with similar legal liability, they wrote.

No Advisory Relationships

Fitch spokesman James Jockle said it doesn't have advisory relationships with companies it rates or structure transactions. While "there is an iterative process between the issuer'' and the firm, "the issuer can make whatever decision they want to make to meet the thresholds that we've established,'' he said.

Moody's doesn't participate in the design and construction of bonds, said Anthony Mirenda, a spokesman. ``Our methodologies are transparent and published on our public Web site'' for both issuers and investors, he said.

S&P spokesman Chris Atkins said that "all courts have consistently recognized that S&P and other rating agencies are entitled to the same First Amendment protections as other financial publishers.''

Much of the problem lies with investors who rely too heavily on ratings, says Michael Bykhovsky, chief executive officer of Applied Financial Technology Inc., a San Francisco- based firm that provides bond models. "It's the investors that have been screwing up,'' he said at a conference in Miami last week.

'Qualified' Protection

A federal district court in Texas in 2005 found only a "qualified'' protection for the firms related to free-speech rights, Partnoy wrote in his 2005 paper. They were dismissed as defendants in the case, in which a Connecticut agency sought to recover $200 million of public funds lost on a loan to Enron.

At Moody's Corp., whose profit has more than doubled in the past four years, structured-finance business is the company's fastest-growing. S&P is owned by McGraw-Hill Cos., while Fitch is a unit of France's Fimalac SA. Shares of Moody's, which have more than doubled since 2002, fell $1.38, or 2.1 percent, to $65.56 at the close of New York Stock Exchange composite trading.

Dale Ledbetter, a partner at Ledbetter & Associates PA in Fort Lauderdale, Florida, said that he's considered naming the ratings firms as defendants in a series of lawsuits he's filing against issuers and others on behalf of bond investors.

The first of the cases, in which Bankers Life Insurance Co. of Fort Lauderdale sued Zurich-based Credit Suisse Group last month over 2001 subprime-loan bonds, didn't name them because it wasn't clear whether they knew of the alleged misdeeds, he said.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.