The California Public Employees Retirement System, or CalPERS, is the US’s largest pension fund which provides retirement benefits to 1.6 million public employees. It’s also one of the most active proponents of good corporate governance on both a domestic and global stage. The latest target of their ire is the credit rating industry which it blames for $1 billion of losses incurred during the crash.

In a lawsuit, filed  last week in California Superior Court in San Francisco, CalPERS alleges that the ratings issued by Moody’s Investor Services, McGraw Hill and Fitch Ratings were “wildly inaccurate and unreasonably high” as well as being, “seriously flawed in conception and incompetently applied”.  The allegations are focused on the complex packages of securities which included subprime mortgages called Structure Investment Vehicles (SIVs). CalPERS invested $1.3 billion of them in 2006 and lost almost everything when the sub-prime crisis hit in 2007 and 2008.

CalPERS asserts that by giving the SIVs the highest possible rating – AAA – the agencies “made negligent misrepresentation” to the fund.  Although CalPERS is seeking damages, the suit does not specify an amount. This has led to speculation that CalPERS’ motives go beyond financial restitution (which California is in desperate need of) and are potentially focusedon using the court system to speed up the reform of the credit rating business and a break-up of the credit rating oligopoly.

Credit rating agencies have been the focus of harsh criticism over their role in the market collapse. Critics contend that instead of being investor watchdogs, the agencies were more motivated by the very generous remuneration  they received for giving their stamp of approval on many of the securities linked to subprime mortgages thus creating an overwhelming conflict of interest.

Conflicts of interest by the rating agencies are rife according to CalPERs. The fees paid to the ratings agencies by the companies issuing the securities effectively bars the agencies from issuing negative ratings and so act as a disincentive for them to be vigilant on behalf of investors. It is revealed that all three agencies involved in the SIVs in question received substantial fees  ranging from $300,000 to $500,000 and as much as $1 million for helping to structure each deal as well as rating them.

In the case of the securities at they heart of the CalPERS claim, it is stated that they were so complicated that only the hedge funds that created them,  Stanfield Capital Partners, Sigma SIV and Cheyne Capital Management, and the three ratings agencies knew what the packages contained. The exact construction of the vehicles was considered proprietary and investors were not provided with any due diligence material, leaving the fund wholly dependent on the ratings. 

“The ratings agencies no longer played a passive role but would help the arrangers structure their deals so that they could rate them as highly as possible,” according to the CalPERS suit.  The suit also contends that the ratings agencies continued to publicly promote structured investment vehicles while they were downgrading them. Ten days after Moody’s had downgraded some of the SIVs in 2007, it issued a report titled “Structured Investment Vehicles: An Oasis of Calm in the Subprime Maelstrom.”

So far, the credit rating agencies involved have yet to make a public statement. When they do it’s likely they will raise the issue of conflicts of interest in their own defence. The employees of the California courts system are all beneficiaries of the CalPERS funds.

Last Updated: 16 July 2009