A recent court ruling is a timely reminder that investment ratings houses are not perfect, writes Mike Taylor.
Ratings houses such as Standard & Poor’s (S&P) have arguably been allowed to wield inordinate influence over the past 20 years with, at one level, Governments worrying about keeping a “Triple A” rating while, at quite another level, financial planners have worried about their assessment of companies such as Basis Capital and Astarra.
Thus, last week’s Federal Court ruling that S&P’s rating of complex financial products such as collateralised debt obligations (CDOs) was misleading should act as a reminder to all those involved in the financial services industry that ratings houses are far from infallible.
Indeed, it should act as a reminder that ratings houses are commercial enterprises which can and do represent useful sources of research-based information about specific financial products but, on occasion, their assessments are as flawed as the products they are asked to rate.
For the record, the Federal Court found that S&P and investment bank ABN Amro misled investors and breached their duty of care when they gave complex risk products an AAA rating.
It was that AAA rating which, it was argued, convinced many NSW local councils to invest in the complex products.
S&P has rejected the court’s findings and has said it will be appealing its decision.
If readers were in any doubt about the fallibility of ratings houses, they ought to consider the occasions on which some of those companies have launched their own financial products into the market – and the relative performance of those products.
In a nutshell, putting aside commercial models and remuneration formulas, ratings houses are only as good as their personnel and their methodology – something which becomes evident each time Money Management conducts its Ratings House of the Year exercise.
Indeed, the Ratings House of the Year series has consistently revealed that, in similar fashion to the manner in which the departure of a key investment manager can change a fund’s rating, the departure of key personnel from a ratings house can alter market perceptions, and sometimes lead to the loss of research mandates.
The manner in which ratings houses operate and their influence on investment outcomes are such that they have long been required to hold an Australian Financial Services Licence. Also, there has been considerable discussion about the need for further regulatory oversight, not least with respect to their underlying business models and potential for conflicts of interest.
However, if there is one recurring theme to much of the analysis, it is that participants in the Australian financial services industry should not seek to rely on ratings houses as a means of outsourcing their responsibility for ensuring a client’s best interests.
