Frank Partnoy: Rating The Wall Street Ratings Agencies When Standard & Poor's recently lowered the U.S. government debt rating for the first time in history, it set off a firestorm of criticism, from the Obama administration to Wall Street. The downgrade raised questions about the influence of S&P and other agencies, which also faced blame in the financial crisis of 2007-'08.
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Rating The Wall Street Ratings Agencies

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Rating The Wall Street Ratings Agencies

Rating The Wall Street Ratings Agencies

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This is FRESH AIR. I'm Dave Davies, sitting in for Terry Gross, who's off this week.

On August 5th, Standard and Poor's took the unprecedented step of downgrading the credit rating of the United States from AAA to AA+. A credit rating is a measure of the likelihood that a company or government will repay its debt. A downgrade can make borrowing more costly and make it harder for a country to pull out of a financial slump.

In explaining its downgrade, Standard and Poor's said the agreement reached on raising the nation's debt ceiling fell short of what was needed, and it said political wrangling in Washington raises questions about the country's ability to address its problems.

The S&P downgrade has been controversial. The other two major ratings agencies, Moody's and Fitch's Investor Service, affirmed the U.S.'s AAA rating. President Obama said the U.S. would pay its debts and would always be a AAA country.

While the downgrade was followed by big swings in the stock market, investors eagerly bought the very U.S. Treasury bonds whose ratings Standard and Poor's downgraded. The ratings agencies were also widely criticized for high ratings they gave to mortgage-backed securities that played a key role in the financial meltdown in 2008.

To better understand credit rating agencies and how they came to have such a powerful impact on the economy, we turn to Frank Partnoy. He's currently a professor of law and finance and co-director of the Center for Corporate and Securities Law at the University of San Diego Law School. In the 1990s he worked with derivatives on Wall Street.

Frank Partnoy, welcome back to FRESH AIR. Historic moment for credit rating agencies here: Standard and Poor's has downgraded the credit of the United States, something many people thought they'd never live to see. First of all, what do you think of the decision of the downgrade?

Mr. FRANK PARTNOY (Professor, University of San Diego Law School): I don't think much of it. They made this decision on August 5 to downgrade the rating from AAA to AA+. So it's not a major downgrade to default levels. They're not saying the United States is going to default. But they are saying that the chances of the United States defaulting are higher, and I don't think that that's right. I think most investment professionals don't think that that's right. Warren Buffett doesn't think that that's right.

And the process that S&P used in reaching this decision didn't reflect very well on it. It made this massive error in overestimating the amount of debt in 2021, that it was projecting the U.S. to have a $2.1 trillion mistake that the Treasury had to point out to it.

And I think most importantly, the markets reacted to S&P's decision to downgrade in the exact opposite way that you would expect. So instead of prices going down, prices went up. People looked at United States treasuries and said: Oh, we're going to buy these, this is a good place to invest, it's still just as safe.

And I think that that is consistent with how the markets have reacted to S&P over the years. It's a great paradox of these credit rating agencies that they change these ratings in ways that have very little informational value. It doesn't actually tell us anything about the chances of the U.S. defaulting or Enron defaulting or subprime mortgage securities defaulting. It's not useful information, and yet it's front-page news. It's incredibly important to people. They want to focus on it.

And I think this is the great paradox of credit rating agencies, that they have so little informational value, and yet they're so important.

DAVIES: I mean, there was a lot of volatility in the stock market. I mean, do you see any harmful effects from the downgrade?

Mr. PARTNOY: Well, I do think one harmful effect was that it just triggered the memories of investors about how little confidence there is in the rating agencies and yet how central they are to the markets. And markets really do depend on faith. There's a kind of magic in the trust of the markets.

And when people see S&P doing something like downgrading the U.S. debt, and they know that S&P occupies this kind of centerpiece in the financial markets, they lose a lot of that faith, and that contributes to volatility, because then they start looking more closely at their investments, and they wonder, well, should I really own this much stock, or should I really own banks now, and they sell and they buy and there's a tremendous amount of volatility as people try to figure out what assets actually are worth.

So in some ways what happened was the downgrade, even though it wasn't meaningful for the Treasury market, it actually spooked a lot of retail investors and people, average individuals, who own stocks, who are now thinking that some of the confidence that they had in S&P and the U.S. government has been shattered. Oh, my gosh. What do we do?

And we saw a week or so of tremendous volatility as people tried to piece together that story. But it didn't really affect the bond market, where the underlying downgrade was.

DAVIES: And as you look at other countries and their ratings, I mean, should the United States have a lower rating than other countries that are AAA?

Mr. PARTNOY: I don't think so. If you look out at other countries that have these high ratings, and you compare the U.S. on a long-term basis, certainly the U.S. economy is not healthy right now, and the long-term prospects in terms of our deficit are dire and will require remarkable political change in order to cover our future costs, compared to France or Germany and certainly Spain, the U.S. is in pretty darn good shape.

And the likelihood of the U.S. defaulting on bonds that it's issuing right now is very, very small, and I think large institutional investors are saying that, and it's reflected in prices.

Now, that doesn't mean that everything is great in our economy or that we don't have some serious work to do on the fiscal side over the next decades. But it does mean that the probability of default is low and that the United States is a lot better off than many countries in Europe that have similar or even higher ratings.

DAVIES: What was the role of the rating agencies in the financial collapse of 2008?

Mr. PARTNOY: The ratings agencies were absolutely at the center of the financial crisis. They enabled and facilitated all of the complex financial instruments that really were at the core of why the markets melted down, first in 2007 and then in 2008.

So what they did, basically, was initially rate mortgage-backed securities, these were the bundles of prime and subprime mortgages that investors bought, and then kind of in a second wave of ratings, they took those packages of mortgage-backed securities and they rated bundles of those bundles, which were variously called collateralized debt obligations. They had all kinds of fancy, complicated names.

But basically what they were doing was repackaging things that they had already rated. And the reason there was such a big problem in 2007 and 2008 was that they had taken subprime mortgage bundles that initially had low ratings, and when they were then bundled a second time, they gave them much, much higher ratings. And it turned out that those high ratings were false and they had to downgrade them, and the downgrade was what caused the collapse of Lehmann Brothers and nearly many other banks and nearly the entire financial system.

DAVIES: So there were these financial instruments, which were essentially very, very risky, which the ratings agencies rated as very safe.

Mr. PARTNOY: Basically that's right. Some of them were very risky. Some of them were not as risky. But essentially what happened was in this bundling process, they used complicated mathematical models. They got away from the intuition of what actually was behind these things, which were people who were borrowing more money than they should have to buy a house, and they abstracted so far away from that that these complicated financial instruments ended up with AAA ratings, the highest possible rating you could get.

DAVIES: And if they had done what they're theoretically supposed to do, which, you know, get real information and make sound independent judgments, and told the world that in fact these instruments were actually risky, how might history have gone differently?

Mr. PARTNOY: If they had done what they were supposed to do, these would not have been rated AAA. They would have been rated AA or single-A or BBB or maybe even further down the scale. And if they were rated lower, then large institutional investors wouldn't have bought them, and at the major banks people would have seen flashing red lights that said, oh, these things are risky. The problem was that when people looked at these instruments, they saw AAA, and they believed that it was actually AAA. And in fact, it wasn't.

DAVIES: Okay, let's talk about how we got here. Give us a little history. When did these ratings originate? Where did they come from?

Mr. PARTNOY: The idea of letter ratings started with John Moody in 1909. He was building on a history of mercantile agencies that had put together lists of people's credit, sort of the same way companies put together our FICO scores or our credit ratings for all kinds of people in businesses that we deal with.

Well, there were businesses that did that, starting with the silk industry in the 1900s, where people kept lists of who was defaulting and who was not defaulting, and John Moody came up with the idea in 1909 of not just providing lots of financial information about companies and railroads - because most of the investments that were available in the early 20th century were railroad bonds - and he said, well, I wonder if I just gave people a simple mnemonic device, instead of giving them all the details, if I just boiled everything down into a letter or a bunch of letters.

And it would start with AAA. AAA would be the safest. And then it would go down, AA, single-A, BBB and so forth, all the way down to D, kind of like the grades I give my students in law school, ranging all the way from the top down to the bottom, D being default. And this caught on, and people started buying a book that he published called "The Analysis of Railroad Investments."

And they bought it primarily because he was able to boil down a lot of complicated information about railroad bonds into a simple letter rating.

DAVIES: So he would get information about the companies and their creditworthiness and then publish this information, boil it down into simple, easy-to-understand ratings like grades, and he would make money by selling that to investors, right? They would pay for his information, for his little book.

Mr. PARTNOY: That's exactly right. So if you were an investor, and you wanted to buy some railroad bonds, you would go to John Moody, and you pay him for this book, and then you would run your finger down the page, and you'd say, oh, the Chicago Rock Island and Pacific looks good, it's rated AAA, I think I'll buy that bond.

DAVIES: Okay, and other ratings agencies emerged, and at some point, as the century progressed, they got some official recognition from the government. Explain that.

Mr. PARTNOY: That's right. The rating agency business wasn't a very good business. They had existed for decades and decades, but during the '40s, '50s, '60s, into the '70s, they hadn't made a lot of money. They were selling their ratings to investors at relatively low prices. Once the ratings were out there, once you knew that the Chicago Rock Island and Pacific was rated AAA, that information was a public good, it could be distributed, and so they weren't able to make a lot of money.

And then what happened in the mid-1970s was some regulators at the Securities and Exchange Commission decided that they would anoint a small group of rating agencies to do some of their work for them.

The SEC, the Securities and Exchange Commission, had the job of figuring out how much capital, how much money, broker-dealers, basically investment banks, would have to set aside in order to remain safe. And that was a hard job for the regulators to do.

And so they said, okay, we're going to designate these agencies. They used a mouthful of acronym: NRSRO, Nationally Recognized Statistical Rating Organization, and they said we're going to designate you as an NRSRO, and what that means is that you do our work for us.

You go out and you rate these bonds, and more and more regulators saw, hey, this is a good idea, we don't have to do our job, we can get Standard and Poor's and Moody's to do our job for us. And so instead of having regulations say you can only own bonds that are safe, they would say you can only own bonds that are AAA or that are AAA or AA.

And thousands and thousands of rules, a web of regulation, grew over the most recent decades to essentially make it so that if you're a company and you want to borrow, and you want a large institutional investor to buy your bonds, you've got to get a rating. There's just no choice.

DAVIES: Now, weren't there also specific requirements that institutions whose stability we really value, like pension funds and banks, their investments were limited to some of the safest stuff, and the rating agencies became the official arbiters of what is safe, right?

Mr. PARTNOY: That's exactly right. So for example, we put our money into money market funds or mutual funds, and what those mutual funds can buy is dictated by a rule that depends on ratings. They can only buy bonds that are rated in the top two categories.

We have our money with insurance companies or pension funds, and various regulations of pension funds and insurance companies also are dictated by what Moody's and Standard and Poor's, these select rating agencies, say, whether they say it's AAA or AA.

There are international rules, the Basil Capital Rules, which set rules for global banks. They also depend on what the rating agencies say. And so over time we've created this very strange business model for the ratings agencies where, regardless of whether we think their ratings have value, whether we think that this bond actually is AAA, that doesn't matter. It's got to be AAA in order to be sold, whether the AAA rating is accurate or not.

DAVIES: We're speaking with Frank Partnoy. He is a professor of law and finance at the University of San Diego. We'll talk more after a short break. This is FRESH AIR.

(Soundbite of music)

DAVIES: If you're just joining us, our guest is Frank Partnoy. He is a professor of law and finance at the University of San Diego. He once worked on Wall Street and has written about financial regulation. We're talking about the Wall Street ratings agencies.

Now, there's another important development here. In the early days of ratings, it would be the investors who would pay for this information because they wanted to know what was safe and what wasn't. That's changed. Explain that.

Mr. PARTNOY: And that's a key point, and it changed, not coincidentally, at exactly the same time that the regulations changed in the 1970s. So remember, back in the early part of the 20th century, when John Moody was first developing his "Analysis of Railroad Investments" manual, you would get that as an investor buy buying it, by paying John Moody for this book. So it was what's called the investor-pay model.

In the mid-1970s, as these rules appeared, the payment model changed to what people call the issuer-pay model, so that if you're a company, if you're IBM, and you're looking to borrow money, you want to issue bonds, you now are the one who's going to S&P and Moody's, and you're paying them a fraction of a percent of the entire size of the issue for their rating.

So there was this shift, a fairly dramatic shift, from the investor paying to the issuer paying, and as you can imagine, people were quite critical of this because they said it created the potential for a conflict of interest.

I mean, you can imagine the difference between how credible ratings of movies or ratings of restaurants might be if instead of it being the Michelin Guide that investors buy, or the Zagat guide, or pick your favorite movie reviewer, instead of the investors paying, if the movie companies themselves or the restaurants themselves were paying the raters to be rated, it's an obvious conflict of interest. But nevertheless that's how the model shifted in the 1970s, and now it's very commonplace that companies, governments, anyone who wants to borrow money, they are the ones who are paying for their rating.

DAVIES: So if I'm going to issue debt, if I'm going to issue bonds, and I'm, you know, a local government or a company, I want the highest rating I can get because that means I will be able to borrow for less interest. And I have an interest in a high rating, and since I'm hiring the rating agency, I can say - I can exert pressure on them to give me a favorable rating. Is that how it works? Is that the concern?

Mr. PARTNOY: That's the concern. The rating agencies will resist this, and they say, oh no, we're not being pressured at all, and we're independent and this is only an opinion, and you shouldn't rely on that in investing anyway, it's just our opinion.

But nevertheless, there is concern that the conflict of interest is real and that there is pressure. And certainly if you look back to the financial crisis, there was tremendous pressure for the rating agencies to come up with AAA ratings, even though what they were rating was essentially junk with subprime bonds that didn't deserve a AAA rating.

And if you go back even in recent history, there are lots of examples of the rating agencies giving very high ratings, many will say under pressure, and then those high ratings not panning out. People may remember Orange County, California's bankruptcy in the mid-1990s. Orange County was rated AA just before its bankruptcy.

People remember Enron. Enron was rated investment-grade just four days before its bankruptcy. AIG had very high ratings just before its collapse. All of the major banks had very high ratings, and so forth.

And so there are allegations that the rating agencies are giving in to this extreme pressure. The allegations now, with the downgrade of the United States, are kind of the opposite, that the rating agencies are trying to show, look, in terms of rating governments, we're not willing to give in, because they've had a bad track record in that area, too.

They rated Iceland AA+ in 2006, and people remember what happened in Iceland. Anyone who's seen the movie "Inside Job" knows it starts out with Iceland and all these bizarre investments in Iceland, and the same thing in Ireland.

And so there is this extreme pressure and accusations that the rating agencies give in to it.

DAVIES: Now, the other way of looking at that is that the rating agencies take their time and will not react quickly to something that's collapsing. I mean, Enron, you had guys who, it's now clear, were fraudulently misleading everybody, including government regulators, about what they're doing.

And I have to say, I mean, I covered the city of Philadelphia for many years as a newspaper reporter, and through a lot of financial crises, and I know that when the city officials from Philadelphia went to Wall Street, to the rating agencies, it seemed to me that the power was all in the rating agencies. It wasn't like they were deciding which rating agency they would hire and could extract from them a favorable rating.

I mean, they went in their Sunday best, with all their charts and graphs, to try and persuade these folks that they deserved a good rating. I didn't sense - I never heard any suggestion that they could influence the rating agencies on their behalf.

Mr. PARTNOY: I think your experience is shared by lots of people who are frustrated by their dealings with the rating agencies. I certainly think Enron was very frustrated with the rating agencies and dealing with them and thought that it deserved a higher rating.

And you know, to be fair to the rating agencies, it is true that they don't react right away, that they don't instantly downgrade when there's bad information.

But I think if you take a step back and ask, well, what is it that we want from the rating agencies, wouldn't we want them to be responsive to information in the market? You'd want them to listen to people at the table and have an open mind when they do hear the kind of criticism that you just described.

And historically, the rating agencies have not. They are quite stubborn and very difficult to persuade, and really if you think across every business, has there - is there any other cluster of companies that has done as bad a job as S&P and Moody's and still remained a viable business over a period of decades? It's extraordinary.

I don't think any other industry has companies that have consistently done their job as poorly, and yet the paradox is that they have remained powerful even in recent weeks.

DAVIES: Frank Partnoy is a professor of law and finance at the University of San Diego Law School. He'll be back in the second half of the show. I'm Dave Davies, and this is FRESH AIR.

(Soundbite of music)

DAVIES: This is FRESH AIR. I'm Dave Davies, sitting in for Terry Gross, who's off this week.

Our focus today is on Wall Street rating agencies, how they work, how they came to have such influence over the economy and how future regulations might affect them. The rating agencies were widely condemned for giving high ratings to risky mortgage-backed securities in the financial meltdown, and Standard & Poor's August 5th downgrade of U.S. credit has been controversial.

Our guest is Frank Partnoy. He's a professor of law and finance at the University of San Diego Law School. In the 1990s, he worked with derivatives on Wall Street and wrote about it in the book "FIASCO: The Inside Story of a Wall Street Trade." He's also the author of "The Match King" and "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets."

Everybody knows that you worked on Wall Street yourself in the 1990s. Talk a little bit about how a rating worked. Where did they get their information?

Mr. PARTNOY: For a complicated instrument, they would get their information from the bank. So I worked at Morgan Stanley, and we would go to the rating agencies - to Standard & Poor's or Moody's, or both -and we would describe a deal that we wanted to do. And it would be very complicated, and they would get their information from us. They had models that they used, but I think it would be fair to say that we were able to run circles around them, that the quality of the rating agency's models was very low, and that they often didn't have a very good understanding of what it was they were rating.

There was one deal in particular that we put together that involved the National Power Corporation of the Philippines bonds, which as you can imagine in the mid-1990s were certainly not rated AAA. There was a lot of risk in the Philippines at the time.

And we went to them, and this was actually a relatively simple structured finance deal, where we put together some U.S. treasuries, some very low-risk instruments, together with the National Power Corporation of the Philippines bonds, some very high-risk instruments. And we went to Standard & Poor's and we said well, will you give this a AAA rating? And, by the way, we'll pay you this very large fee. And they debated for a while and actually gave us a AAA rating.

And it was kind of funny over time, they realized, oh, no. We really should not have given you this AAA rating. And so they introduced something called the [R] Subscript, and they put a little, tiny R at the bottom of the AAA to indicate well, this is not really a AAA rating. I mean, it's National Power Corporation of the Philippines. How could it possibly be AAA?

(Soundbite of laughter)

Mr. PARTNOY: But nevertheless, it was rated AAA. It just had this little R on it.

DAVIES: So it sounds like you and your fellow bankers kind of put one over on the agencies here. Were the underlying assets available for inspection? Was there a material there that, if the rating agencies were more diligent, they could have consulted and gotten a more accurate assessment?

Mr. PARTNOY: Clearly, for this deal that I just described, it was very straightforward. And so that one's easy. And in some ways, you can feel some sympathy for the credit rating agencies in rating these very complicated instruments that have thousands and thousands of subprime mortgages all across the country from lots of different borrowers. But the one I just described for you could not be more simple. It just had two securities in it, and both of them were fully described.

So that - I regarded that one as a really egregious mistake. In some ways, the mistakes that they've made more recently are tougher because they involve complicated math, very high-level understanding of the interrelationships among the subprime mortgages and the securities in these pools, in these packages. So I do have some sympathy, having looked at the testimony from the rating agency employees, that they really were in over their heads.

But nevertheless, I think the right thing to do then if you're in a business and you're over your head is to step back and say, we're not willing to do this anymore. And the employees at the rating agencies who said this is crazy, we've got to stop it, we can't put AAA ratings on this, they were ignored and very much ill-treated.

DAVIES: And how do we know that? I mean, do you know these folks personally?

Mr. PARTNOY: I know some of them. But we know it because they've testified before Congress and various committees. They've come out and some of them have either filed or threatened litigation against the rating agencies. So there have been a few people who have come out and told their stories, and they've given us a lot of details. I think that the Senate Committee, the permanent subcommittee on investigations that looked at the financial crisis and just recently issued a report spent a lot of time talking to people at the credit rating agencies. And for anyone who's angry about the credit rating agencies, that's a good place to start.

There's a very lengthy report that has lots of details and meaty, sometimes profanity-laced footnotes that will give you a pretty clear picture of who inside the rating agencies didn't know what they were doing and who was yelling about it when.

DAVIES: There are three main rating agencies: Standard & Poor's, Moody's and Fitch's. Are there others that have this designation, a nationally recognized statistical rating organization?

Mr. PARTNOY: There are. And over time there was consolidation in the industry, and these became the dominant ones, particularly S&P and Moody's. Even back in the 1990s, they were dominant, and Thomas Friedman had this great quote from 1996, where he said there were two superpowers in the world. There's the United States and there's Moody's. And the United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And that's really the way that it stood for a while, with Moody's and S&P dominating the market share. They had 90-plus percent of the ratings.

Now, more recently, the government has decided they wanted to open up the rating business to competition, and so they've designated some other rating agencies as competitors. But really, S&P and Moody's in particular have had an oligopoly lock on the business. Fitch has been a somewhat distant third, and then everyone else is running very, very far behind in this race. But basically, it's S&P and Moody's.

DAVIES: We're speaking with Frank Partnoy. He is a professor of law and finance at the University of San Diego.

We'll talk more after a break. This is FRESH AIR.

(Soundbite of music)

DAVIES: If you're just joining us, we're talking about the Wall Street rating agencies, their role in the economy, with Professor Frank Partnoy. He is professor of law and finance from the University of San Diego. He studies and writes about financial issues and financial regulation.

I want to talk about what might be different, I mean, if there are problems with all of the power that these credit rating agencies have, and their - questions about their ability to fairly and independently and accurately rate credit. Let's talk about kind of what might be different.

The Dodd-Frank financial reform legislation which passed had some provisions which would change the game for rating agencies, right? Tell us what's going on there.

Mr. PARTNOY: That's right. And really, there are two crucial changes. One is in the area of regulatory reliance on ratings - in other words, this web of regulation that depends on S&P and Moody's, on the credit ratings - like the requirement that your mutual funds buy only bonds that are rated in the top two categories. And what the Dodd-Frank bill did on that was to require that various agencies regulators - remove references to ratings from those rules. It said take them out. Get rid of them. There are thousands of these references all over federal regulation. Get rid of them.

DAVIES: Now, if I could just - if I can just cut in here, what that would do would say - it would continue to say to these institutions like banks and pension funds: You have to make sound investments, but you don't have to rely upon the ratings of these agencies.

Mr. PARTNOY: Yes. That's correct. And the challenge has been for regulators to come up with some substitute. Well, what else are you supposed to do if you're a pension fund, if you're an insurance company, if you're a money market fund, what should you look at? Should you just do your own credit analysis? Is it permissible to look at ratings? And there's been a lot of confusion and debate in Washington about what the substitutes will be.

There's some pressure for a proposal that I've advocated for a while, which is to rely on market prices, to look at the markets as one reference point for deciding whether or not something is creditworthy so that you reflect information and wisdom from a variety of market participants. And that is showing up in some of the regulatory changes.

There's pressure from many fronts to continue to be able to use ratings, at least in a secondary role. There's a big debate that's happening in Washington about that right now. But Congress has basically told regulators: Get rid of these references.

And I'm very optimistic that if regulators are able to do that over the next year or so, that over time, over a period of years, that we'll end up weaning ourselves off of this dependence on ratings and that the markets will end up being a lot safer as a result in the long-term.

DAVIES: Now, if I'm Standard & Poor's or Moody's, and I'm rating literally thousands of bond issues every year, getting paid every time I do it, I would have to view this new change as a threat to my financial health. How are they reacting?

Mr. PARTNOY: Interestingly, they haven't reacted that way. Maybe internally, in their discussions, they see this as a problem. But they have said that they will go along, and that they believe that their business will survive and thrive in a kind of independent market for ratings. And the jury is out on that.

Moody's shares are worth over $7 billion right now, and the value there, I think, comes from the importance of the ratings in regulation. But Moody's and S&P, I think, believe that they will be able to survive, even if there aren't these kinds of regulatory references to their ratings. And I think that - let's give them a shot. Let's see if they do.

DAVIES: And you think that's a good thing, I guess. I mean, if they have to survive on the credibility of their reputation, that's all to the good.

Mr. PARTNOY: I think that's a good thing. But there's a second piece of the regulatory reform which I'm not so optimistic about, and this is forcing the rating agencies to be subject to liability when they issue fraudulent ratings.

In the past, the rating agencies have been insulated from liability. So they've really had the best of both worlds. They've had regulators telling them investors have to use your ratings. It's a must in regulation. But then, if you commit fraud, if you get the ratings wrong and you're sued, you can defend yourself.

And the way that S&P in particular has defended itself is by saying our ratings are just opinions. They're protected by the First Amendment, in the same way what we're saying right now is protected by the First Amendment, or what something I might say in an opinion piece I write for The New York Times or the Financial Times is protected by the First Amendment. And courts generally have accepted this argument. S&P has had a very effective advocate, Floyd Abrams, who's one of the best First Amendment lawyers in the world.

People may remember Orange County, California's bankruptcy. In the mid-1990s Orange County was the rated AA just before its bankruptcy, and S&P was sued. And they settled that case for $149,000, which is nothing to settle a major piece of litigation. They changed their contracts and said that ratings are constitutionally protected, that they're not investment advice. And they've been very effective in making this argument that they have the same kinds of constitutional protections.

Now, it's worth noting that people generally don't get paid by issuers for writing stories about them. So The New York Times, for example, isn't compensated when it writes a story about Google. Google doesn't pay it for writing that story, whereas issuers of bonds pay S&P for their ratings, and they won't pay if they don't get a rating. So it's commercial in a way that other kinds of speech are not. But nevertheless, they've been very effective, and I think we'll have to see whether the rating agencies are subject to liability.

You used the word reputation. In order for there to be a well-functioning market for ratings that is constrained by reputation, they have to put their money where their mouth is and be subject to liability in the same way we would be subject to liability if we fraudulently sell something to someone. And so far they haven't.

DAVIES: Well, now, it's one thing to make a mistake. It's another thing to call that fraud. I mean, if, for example, I bought a bond that Standard & Poor's had rated A-minus, and I think that company really isn't that good. It's a BB. And I think, therefore, I should have gotten a better yield on my bond if they had gotten that rating just right. Do you think I should be able to sue them for saying you slightly overvalued their credit, therefore I got ripped off for, you know, a relatively small amount of money? I mean, should you really expect them to know everything there is about a company they're rating?

Mr. PARTNOY: No, of course not. And you very well might lose that lawsuit. But what I think shouldn't happen is that S&P should be able to defend itself by saying this is just an opinion. It's protected by the First Amendment. I think what should happen is if you believe there are circumstances that would support a claim for fraud or some other kind of claim, that you should be able to sue them and have a judge look at the case and decide whether or not to dismiss the case based on the facts, and that they shouldn't be able to hold up the First Amendment as a shield to protect them against all the arrows of these potential lawsuits.

Now not everybody's going to win, I agree. And many people make mistakes in investing, and you don't want to constantly hold people liable for making mistakes. But the courts do a pretty good job of going through that, and I don't think everyone would win. So what I'm saying is something very different, which is this particular argument that they've been able to make, they shouldn't be able to make anymore.

DAVIES: But haven't their ratings always come with this language that says these are not indications of investment merit, they are not buy, sell or hold recommendations? It's not a measure - haven't they always had that language?

Prof. PARTNOY: They haven't always. And that language has evolved over time. And they got especially excited about that language after they got the favorable settlement in the Orange County litigation. But certainly, today, ratings all say that. So if you look at the ratings, the rating agencies are clearly, in advance, claiming First Amendment protection. That doesn't mean that a judge should buy their argument. Many people think that argument is specious. But they clearly say in advance that these ratings are opinions and you shouldn't rely on them.

It's interesting that they say this, and yet whenever they downgrade a significant issuer - like the August 5th downgrade of the United States - it's front-page news every day. We - this is a great paradox of ratings, that they don't really have a lot of informational value, and even the rating agencies say that they shouldn't be relied on as investment advice. And yet they're front page news. They're something that we care a lot about.

DAVIES: An alternative to having the rating agencies define what are safe investments is to have the government regulators themselves do it -in other words, have them do ratings or something like them. Is that a realistic proposal?

Prof. PARTNOY: There was a push for this in the U.S., and it was rejected. It's not the kind of thing that we generally do. There is more popularity in Europe. Several European regulators have suggested that this is something that's sufficiently important. It's kind of like public utility, that it's a function that should be performed by the government.

I'm not sure that I would be very comforted by having the solution be to have these regulators who, having deferred to the rating agencies saying they couldn't do this on their own, are now going to be forced to try to do it on their own. I'm not sure that that's the right solution, and I'm not sure people would have any more confidence in the regulator's ability to do a good job. So I'm not a fan of that proposal, but it does have some support in Europe. I doubt it would happen in the U.S.

DAVIES: So how optimistic are you that we're going to get some change and that the role of the rating agencies will, you know, will evolve in a direction that's less harmful?

Prof. PARTNOY: I'm very optimistic, actually. We got some extraordinary change in the Dodd-Frank legislation. This was a time when the rating agencies were beaten down. They had downgraded thousands and thousands of instruments. People understood that they were at the center of the financial crisis, and members of Congress acted. They passed a law that required regulators to take out these references, and they're in the process of doing that.

Now, they're being beaten over the head by lobbyists who don't necessarily want that to happen, but they're trying their best and trying to get rid of those references. And if that happens, I think the long-term implications will be very favorable.

I'm not as optimistic about the accountability of the rating agencies, about whether they will fully be held accountable through either civil liability from private parties suing them or from the government. The government, the Securities and Exchange Commission did an investigation of the credit rating agencies, but essentially let them off with a slap on the wrist. And we haven't seen a criminal prosecution, really, of anyone on Wall Street, but certainly not anyone at the credit rating agencies. And I'm not optimistic that will happen.

So it's a bit of a mixed bag, but I think in terms of what the regulators could have done in response to the crisis - one of the most important things for them to do was to get rid of this reliance on ratings. And they took several steps down that path, and I think we'll end up better off as a result.

DAVIES: Well, Frank Partnoy, thanks so much for speaking with us.

Prof. PARTNOY: Thank you.

DAVIES: Frank Partnoy is the George E. Barrett Professor of Law and Finance and co-director of the Center for Corporate and Securities Law at the University of San Diego Law School. He's also the author of "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets."

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