California Targeting The Rating Agencies

Just yesterday, I wrote about how regulators might be starting to question the heavy involvement of rating agencies in the evaluation of bond insurers. A few weeks before that, I wrote about a judge deciding that the First Amendment's guarantee of free speech does not entirely shield the agencies from lawsuits. In July, I wrote a post about why I believe granting rating agencies that First Amendment protection is absurd. According to news out late yesterday, California agrees with me. The state has launched a probe to determine whether the rating agencies broke state law by incorrectly rating various mortgage-backed securities (MBS).

Here's the news from Reuters, including a quote from California Attorney General Jerry Brown:

The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition.

"The agencies have been coddled and protected," Brown said. "It's time we smoked 'em out."

"The rating agencies historically in my view have hid behind the first amendment," Supervising Deputy Attorney General Kathrin Sears, who heads the probe, told reporters, adding that nothing may come of the probe.

Despite that caveat, it's pretty clear that investors want someone's blood for the losses they incurred on the MBS that the agencies gave favorable ratings. I've argued that investors need to share in some of the blame. After all, investors should perform some of their own due diligence when buying a security. Instead, investors often just accepted agencies' ratings as gospel and naively purchased securities that ended up going terribly wrong.

In the Reuters piece, Brown explains how just badly the agencies got it wrong:

"When the bubble burst, however, those risky mortgages defaulted in record numbers and investors were left holding worthless securities, unable to sell them," the statement said. "Subsequently, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage backed securities, a tacit acknowledgment of their failure to adequately assess the risks of the debt they rated."

Even if investors should have known better, it's hard to not place a great deal of the blame on the rating agencies. After all, it's their business to understand and evaluate the risk in securities. They blew it. And just as a doctor is subject to a malpractice suit for misdiagnosis, I think the rating agencies should be held responsible for flagrantly incorrect ratings. This week we learn that California does too.