Australia rarely gets an opportunity to have any substantial role in the development of what Tom Friedman called the 'Golden Straitjacket': the rules and understandings that govern and support international economic integration. But a recent Australian court judgment may provide a modest contribution to shifting the rules in the right direction.
The story begins three decades ago, with the deregulation of financial markets. Simple bank intermediation was augmented by rapid expansion of capital markets where complex 'structured' financial products were created and traded. The complexity of these products required expert analysis to guide investors. Credit rating agencies (CRAs) provided this. They also acted as gatekeepers: CRA ratings were the basis of defining 'safe' funds and even formed the basis of the Basel Rules on risk which guided bank regulators around the world.
Such was the belief in the 'magic of the market' that the rating agencies, in carrying out this key role, were largely self-regulated. The assumption was that the need to maintain their reputation would provide powerful self-discipline.
The 2008 financial crisis revealed a different reality. The rating agencies had become alchemists, turning dross into gold by endorsing shonky financial products for a fat fee paid by the financial institutions which produced these products. Self-discipline proved illusory.
Yet despite the huge losses made on certified-safe financial instruments which turned out to be very dicey, the rating agencies seemed to be Teflon-coated. They not only avoided any penalties for their profit-driven mis-ratings, but they also dodged fundamental reform.
While various investors have sought redress in the courts, the rating agencies operate under the confident assumption that in the US they are protected by the constitutional right to free speech: their ratings are just an opinion and therefore not subject to complaint. As well, they had the usual fine-print disclaimers.
Now, suddenly, the ground has shifted.
The Standard and Poor's rating of ABN-Amro CPDOs (constant proportion debt obligations) was found by the Australian Federal Court to have deceived and misled investors and that a 'reasonably competent' agency would not have given these instruments a AAA rating. The judgment sets out in 1500 pagers of amazing detail just how S&P went about its business.
These CPDOs were a derivative product based on corporate debt packaged up by ABN-Amro, then sold to various local councils through an intermediary. Within two years of purchase, the 12 local councils involved in this case had lost 90% of their $17 million investment. Local councils are, properly and obviously, conservative investors. They are often unsophisticated in financial matters, relying heavily on advisers to protect the savings of their rate-payers' funds. Thus the AAA rating given by S&P was very important in their investment decisions.
Even with this clear-cut example of the failure of the ratings system, this case will not, in itself, solve the problem. Even if the judgment stands (S&P is appealing), court cases are not enough. Rating agencies don't have large enough balance sheets to take full responsibility for the losses resulting from their negligence. If this decision stands, it will serve to make the CRAs more careful for a while. But memories fade, and their role in the financial sector needs to be redefined.
In tailoring the Golden Straitjacket, the warp of private-sector remedies such as this one has to be held together by the weft of official regulation, however hard this is to put in place in the international context beyond the jurisdiction of any single sovereign. In the face of financial sector lobbying, this official rule-making has been largely ineffectual so far.
Perhaps the Australian judgment will strengthen the arm of the international regulators to take tougher action. They could, for example, require separate agencies to assess government debt, on the one hand, and private companies on the other. Then, at least, it would be blindingly obvious that a AAA rating given to a company that paid for it was not the same as a AAA rating given to a country.
It's not that the rating agencies have done a stellar job in ranking countries: they are always looking in the rear-view mirror, are slow to downgrade failing governments and upgrade better performers only belatedly. Though in comparison with their efforts with the CPDOs, these seem to be honest mistakes.
Photo by Flickr user 3SugarCubes.