CHICAGO — Ohio Attorney General Richard Cordray filed a lawsuit in federal court Friday accusing the three major rating agencies of colluding with banks and issuers of mortgage-backed securities by inflating ratings on the debt, leading to major market losses for investors like Ohio’s pension and retirement funds.
The state claims that Fitch Ratings, Standard & Poor’s, and Moody’s Investors Service played a central role in the recent market collapse by assigning top marks to risky debt in order to earn more fees from issuers.
The subsequent downgrades of the triple-A rated securities amid the housing and market collapse led to losses of more than $457 million for Ohio’s top five pension and retirement funds, according to Cordray.
The case is not aimed at municipal debt. The complaint alleges the role rating agencies played in rating structured finance products such as mortgage-backed securities was far different than the role they play when rating municipal or corporate debt, and that the fees were significantly greater.
The lawsuit is the latest salvo aimed at the rating agencies. In September, California Attorney General Jerry Brown announced he had issued subpoenas to the agencies as part of an investigation into whether they violated state law by giving high ratings to subprime mortgage-backed securities and other debt instruments.
In July, the California Public Employees’ Retirement System sued the agencies, alleging “wildly inaccurate” ratings led to the loss of more than $1 billion.
And Connecticut Attorney General Richard Blumenthal filed suit in July 2008, charging that the agencies gave municipal bonds lower ratings than were merited. That case is pending.
Friday’s lawsuit is the eighth filed by Cordray tied to the impact of the market’s collapse on Ohio’s pension and retirement fund. The 77-page compliant, filed in the U.S. District Court for the Southern District of Ohio, says the agencies knew their ratings were wrong but “succumbed to the attraction of high fees.”
The “opaque and complex nature” of structured finance products — such as asset-backed securities, residential mortgage-backed securities, and commercial mortgage-backed securities — made ratings crucial for investors like Ohio’s funds, the complaint says.
Unlike with municipal or corporate-backed debt, rating agencies “worked backward” to achieve the ratings of mortgage-backed debt by working with banks and issuers to achieve the desired rating, and became “intimately involved” in the issuance of the debt, the complaint says.
“The rating agencies would not receive their full fees unless the issuance of the [asset-backed security] was completed and the target rating was attained. Therefore, both the issuers and the rating agencies were highly incentivized to agree to the targeted ratings so that the ABS could be marketed to investors like the Ohio funds, which were interested in purchasing the highest investment-grade securities,” the complaint says. “In the words of one former Moody’s executive for structured finance products, 'The ratings process became a negotiation.’ ”
The lawsuit is being brought on behalf of the Ohio Public Employees Retirement System, the State Teachers Retirement System of Ohio, the Ohio Police and Fire Pension Fund, the School Employees Retirement System of Ohio, and the Ohio Public Employees Deferred Compensation Program.
Municipal credit analysts note that overall, the state’s pension and retirement funds are considered well funded and conservatively managed.
Michael Adler, a spokesman for Moody’s, called the lawsuit “without merit” and said Cordray appeared to be “seeking new scapegoats for investment losses that occurred during an unprecedented global market disruption.”
Standard & Poor’s spokesman Steven Weiss said the claim was without merit. “We will vigorously defend ourselves against it,” he said.
Fitch was not available to comment.