Ron Grassi says he thought he had retired five years ago after a 35-year career as a trial lawyer.
Now Grassi, 68, has set up a war room in his Tahoe City, California, home to single-handedly take on Standard & Poor's, Moody's Investors Service and Fitch Ratings. He's sued the three credit rating firms for negligence, fraud and deceit.
Grassi says the companies' faulty debt analyses have been at the core of the global financial meltdown and the firms should be held accountable. Exhibit One is his own investment. He and his wife, Sally, held US$40,000 ($62,000) in Lehman bonds because all three credit raters gave them at least an A rating - meaning they were a safe investment - right up until September 15, the day Lehman filed for bankruptcy.
"They're supposed to spot timebombs," Grassi says. "The bombs exploded before the credit companies acted."
As the US and other economic powers devise ways to overhaul financial regulations, they have yet to come up with plans to address one issue at the heart of the crisis: the role of the rating firms.
That's partly because the reach of the three big credit raters extends into virtually every corner of the financial system. Everyone from banks to the agencies that regulate them is hooked on ratings.
Even the plans crafted by US Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner to stimulate the economy count on ratings firms to determine how the money will be spent.
"The key to policy going forward has to be to stop our reliance on these credit ratings," says Frank Partnoy, a professor at the San Diego School of Law and a former derivatives trader who has written four books on modern finance, including Infectious Greed: How Deceit and Risk Corrupted the Financial Markets.
"Even though few people respect the credit raters, most continue to rely on them," Partnoy says. "We've become addicted to them like a drug, and we have to figure out a way to wean regulators and investors off of them."
Investors, traders and regulators have been questioning whether credit rating companies serve a good purpose ever since Enron imploded in 2001. Until four days before the Houston-based company filed for what was then the largest-ever US bankruptcy, its debt had investment-grade stamps of approval from S&P, Moody's and Fitch.
In the run-up to the current financial crisis, credit companies evolved from evaluators of debt into consultants.
They helped banks create US$3.2 trillion of sub-prime mortgage securities. Typically, the firms awarded triple-A ratings to 75 per cent of those debt packages.
"Ratings agencies just abjectly failed in serving the interests of investors," says Kathleen Casey, a commissioner at the Securities and Exchange Commission (SEC).
The president of S&P, Deven Sharma, says he knows his firm is taking heat from all sides - but he expects to turn that around.
"Our company has always operated by the principle that if you do the right thing by the customers and the market, ultimately you'll succeed," Sharma says.
The chief executive of Moody's, Raymond McDaniel, and Fitch chief Stephen Joynt declined to comment for this story.
"We are firmly committed to meeting the highest standards of integrity in our ratings practice," McDaniel said at an April 15 SEC hearing.
"We remain committed to the highest standards of integrity and objectivity in all aspects of our work," Joynt told the SEC.
Despite the role the credit companies played in fomenting disaster, the US Government is now relying on them to help fix the system they had a hand in breaking.
The Federal Reserve's Term Asset-Backed Securities Loan Facility, or TALF, will finance the purchase by taxpayers of as much as US$1 trillion of new securities backed by consumer loans or other asset-backed debt - on the condition that they have triple-A ratings.
And the Fed has also been buying commercial paper directly from companies since October, but only if the debt has at least the equivalent of an A-1 rating, the second-highest for short-term credit. The three rating companies graded Lehman debt A-1 the day it filed for bankruptcy.
The Fed's financial rescue is good for the bottom lines of the three rating firms, says Connecticut Attorney General Richard Blumenthal, who believes they could enjoy as much as US$400 million in fees that come from taxpayer money. The Federal Reserve has since cleared two other agencies, as well as the big three, to provide ratings for the scheme.
At the core of the rating system is an inherent conflict of interest, says Lawrence White, the Arthur E Imperatore Professor of Economics at New York University in Manhattan. Credit raters are paid by the companies whose debt they analyse, so the ratings might reflect a bias, he says.
"So long as you are delegating these decisions to for-profit companies, inevitably there are going to be conflicts," he says.
In a March 25 report, policy makers from the Group of 20 nations recommended that credit rating companies be supervised to provide more transparency, improve rating quality and avoid conflicts of interest. The G-20 didn't offer specifics.
While lawmakers scratch their heads over how to come up with an alternative approach, the rating firms continue to pull in rich profits.
Moody's, the only one of the three that stands alone as a publicly traded company, has averaged pretax profit margins of 52 per cent over the past five years. It reported revenue of US$1.76 billion - earning a pretax margin of 41 per cent - even during the economic collapse last year.
Moody's, S&P and Fitch control 98 per cent of the market for debt ratings in the US, according to the SEC. The noncompetitive market leads to high fees, says SEC commissioner Casey. S&P, part of McGraw-Hill, has profit margins similar to those at Moody's, she says.
"They've benefited from the monopoly status that they've achieved with a tremendous amount of assistance from regulators," Casey says.
But Sharma says S&P has justifiably earned its income.
"Why does anybody pay US$200, or whatever, for Air Jordan shoes?" he asks, sitting in a company boardroom high over the southern tip of Manhattan. "It's the same. People see value in that. And it all boils down to the value of what people see in it."
Blumenthal says he sees little value in credit ratings. He says raters shouldn't be getting money from federal financial rescue efforts.
"It rewards the very incompetence of Standard & Poors, Moody's and Fitch that helped cause our current financial crisis," he says. "It enables those specific credit rating agencies to profit from their own self-enriching malfeasance."
Blumenthal has subpoenaed documents from the three companies to determine if they improperly influenced the TALF rules to snatch business from smaller rivals.
S&P and Fitch deny the accusations.
"The investigation by the Connecticut attorney general is without merit," says S&P vice-president Chris Atkins. "The attorney general fails to recognise S&P's strong track record rating consumer asset-backed securities, the assets that will be included in the TALF programme. S&P's fees for this work are subject to fee caps."
Fitch managing director David Weinfurter says the Government makes all the rules - not the rating firms.
"Fitch Ratings views Blumenthal's investigation into credit ratings eligibility requirements under TALF and other federal lending programmes as an unfortunate development stemming from incomplete or inaccurate information," he says.
Moody's senior vice-president, Anthony Mirenda, declined to comment.
Sharma says it's clear that his firm's housing market assumptions were incorrect. S&P is making its methodology clearer so investors can better decide whether they agree with the ratings, he says.
"The thing to do is make it transparent, 'Here are our criteria. Here are our analytics. Here are our assumptions. Here are the stress-test scenarios. And now, if you have any questions, talk to us,"' Sharma says.
The rating companies reaped a bonanza in fees earlier this decade as they worked with financial firms to manufacture collateralised debt obligations. Those creations held a mix of questionable debt, including sub-prime mortgages, car loans and junk-rated assets.
Moody's, S&P and Fitch won as much as three times more in fees for grading structured securities than they charged for rating ordinary bonds.
The CDO market started to crash in mid-2007, as investors learned the securities were jammed with bad debt.
Alex Pollock, now a resident fellow at the American Enterprise Institute in Washington, says more competition among credit raters would reduce fees.
"The rating agencies are an SEC-created cartel," he says. "Usually, issuers need at least two ratings, so they don't even have to compete."
Pollock was president of the Federal Home Loan Bank in Chicago from 1991 to 2004. The bank was rated triple-A by both Moody's and S&P. He says he recalls an annual ritual as he visited representatives of each company.
"They'd say, 'Here's what it's going to cost,"' he says. "I'd say, 'That's outrageous.' They'd repeat, 'This is what it's going to cost.' Finally, I'd say, 'OK'. With no ratings, you can't sell your debt."
Congress has held hearings on credit raters routinely this decade, first in 2002 after Enron and then again each year until 2008. In 2006 Congress passed the Credit Rating Agency Reform Act, which gave the SEC limited authority to regulate raters' business practices.
The SEC adopted rules under the law last December, banning rating firms from grading debt structures they had designed themselves. The law forbids the SEC from ordering the firms to change their analytical methods.
Only the US Congress has the power to overhaul the rating system. So far, nobody has introduced legislation that would do that. In a hearing on April 15, the SEC heard suggestions for legislation on credit raters. Some of the loudest proponents for change are in state government and on Wall Street. But no one's agreed on how to do it.
"We should replace ratings agencies," says Peter Fisher, managing director and co-head of fixed income at New York-based BlackRock, the largest publicly traded US asset management company.
"Our credit rating system is anachronistic," he says. "Eighty years ago, equities were thought to be complicated and bonds were thought to be simple, so it appeared to make sense to have a few rating agencies set up to tell us all what bonds to buy. But flash forward to the slicing and dicing of credit today, and it's really a pretty wacky concept."
To create competition, the US should license individuals, not companies, as credit rating professionals, Fisher says. They should be more like equity analysts and would be primarily paid by institutional investors. Neither equity analysts nor those who work at rating companies currently need to be licensed.
Such a system wouldn't be fair, says Daniel Fuss, vice-chairman of Boston-based Loomis Sayles, which manages US$106 billion. An investor-pays ratings model may give the biggest money managers a huge advantage over smaller firms and individuals because they can afford to pay for the analyses, he says.
"What about individuals?" he asks.
Eric Dinallo, New York's top insurance regulator, proposes a government takeover of the rating business.
"There's nothing wrong with saying Moody's or someone is going to just become a government agency," he says. "We've hung the entire global economy on ratings."
Insurance companies are among the world's largest bond investors. Dinallo suggests that insurers could fund a credit rating collective run by the National Association of Insurance Commissioners, a group of state regulators.
"It would be like the Consumer Reports of credit ratings," Dinallo says, referring to the not-for-profit magazine that provides unbiased reviews of consumer products.
But turning over the credit ratings to a consortium headed by state governments could lead to lower quality because there would be even less competition, Fuss says.
"I would be strongly opposed to the Government taking over the function of credit ratings," he says. "I just don't think it would work at all. The business creativity, the drive, would go straight out of it."
At the April 15 SEC hearing, Joseph Grundfest, a professor at Stanford Law School in Stanford, California, suggested a variation of Dinallo's idea. He said the SEC could authorise a new kind of rating company, owned and run by the largest debt investors.
All bond issuers that pay for a traditional rating would also have to buy a credit analysis from one of these firms.
SEC commissioner Casey has another solution. She wants to remove rating requirements from federal guidelines. She also faults investors for shirking their responsibility to do independent research, rather than simply looking to the grades produced by credit raters.
"I'd like to promote greater competition in the market and greater discipline," she says. "Eliminating the references to ratings will play a huge role in removing the undue reliance that we've seen."
S&P's Sharma says that even with widespread regulatory reliance on ratings, his firm will lose business if investors say it doesn't produce accurate ones.
"Our reputation is hurt now," he says. "Let's say it continues to be hurt; it never comes back. Three other competitors come back who do much better-quality work. Investors will finally say, 'I don't want S&P ratings."'
S&P has incorporated so-called credit stability into its ratings to address the risk that ratings will fall several levels under stress conditions, which is what happened to CDO grades. The company has also created an ombudsman's office in an effort to resolve potential conflicts of interest.
Lynn Tilton, who manages US$6 billion as chief executive of private equity firm Patriarch Partners in New York, says she woke up one morning in August 2007 convinced the banking system would collapse and started buying gold coins.
"I predicted the banks would be insolvent," Tilton says. "My biggest issue was credit-default swaps. When the size of that market started to dwarf gross domestic product by six or seven times, then my understanding of what defaults would be in a down market became clear: There's no escaping."
Investors like Tilton watched as the financial firms tumbled while credit raters held on to investment-grade marks.
"If the ratings mandate weren't there, we wouldn't care because the credit-default-swap markets can tell us basically what we want to know about default probabilities," NYU's White says. "I'm a market-oriented guy, so I'm more inclined to be relying on the collective wisdom of the market participants."
San Diego School of Law's Partnoy, who has written law review articles about credit rating firms for more than a decade and has been a paid consultant to plaintiffs suing rating companies, says raters hold back from downgrading because they know the consequences can be dire.
In September, Moody's and S&P downgraded AIG to A2 and A-, the sixth- and seventh-highest investment-grade ratings. The downgrades triggered credit default swap payouts and led to the US lending AIG US$85 billion. The Government has since more than doubled AIG's rescue funds.
"When you get into a situation like we're in right now with AIG, the rating agencies are basically trapped into maintaining high ratings because they know if they downgrade, they don't only have this regulatory effect but they have all these effects," Partnoy says.
"It's all this stuff that basically turns the rating downgrade into a bullet fired at the heart of a bunch of institutions."
Sharma says S&P has never delayed a ratings change because of potential downgrade results. He says his firm tells clients not to use ratings as triggers in private contracts.
"We take action based on what we feel is right," Sharma says.
Moody's was the first credit rating firm in the US, beginning by grading railroad bonds in 1909. Standard Statistics, a precursor of S&P, began rating securities seven years later.
After the 1929 stock market crash, the Government decided it wasn't able to determine the quality of the assets held by banks on its own, Partnoy says. In 1931 the US Treasury started using bond ratings to analyse banks' holdings.
James O'Connor, then comptroller of the currency, issued a regulation in 1936 restricting banks to buying only securities that were deemed high quality by at least two credit raters.
"One of the major responses was to try to find a way - just as we are now with the stress tests and the examination of the banks - to figure out how to get the bad assets off the banks' books," Partnoy says.
Since then, regulators have increasingly leaned on ratings to police debt investing. In 1991 the SEC ruled that managers of money market mutual funds (unit trusts) must put 95 per cent of their investments into highly rated commercial paper.
Like auditors, lawyers and investment bankers, rating firms serve as gatekeepers to the financial markets. They provide assurances to bond investors. Unlike the others, ratings companies have generally avoided liability for errors.
Grassi, the retired California lawyer, wants to change that, and filed his lawsuit against the rating companies in January.
The white-haired lawyer discusses his case seated at a tiny wooden desk in his small guest bedroom, with files spread over both levels of a bunk bed. Grassi says in his complaint that the raters were negligent for failing to downgrade Lehman Brothers debt as the bank's finances were deteriorating.
The day Lehman filed for bankruptcy, S&P rated the investment bank's debt as A, which according to S&P's definition means a "strong" capacity to meet financial commitments. Moody's rated Lehman A2 that day, which Moody's defines as a "low credit risk". Fitch gave Lehman a grade of A+, which it describes as "high credit quality".
"We'd like to have a jury hear this," Grassi says. "This wouldn't be six economists, just six normal people. That would scare the rating agencies to death."
The rating companies haven't yet filed responses. They've asked the federal court in Sacramento to take jurisdiction from the state court.
S&P and Fitch say they dispute Grassi's allegations. "We believe the complaint is without merit and intend to defend against it vigorously," S&P's Atkins says.
Fitch's Weinfurter says: "The lawsuit is fully without merit and we will vigorously defend it."
Mirenda at Moody's declined to comment.
S&P included a standard disclaimer with Lehman's ratings: "Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision."
Grassi isn't deterred.
"They're saying we know you're going to rely on us and if you get screwed, you're on your own because our lawyers have told us to put this paragraph in here," he says.
The companies have defended their ratings from lawsuits, arguing that they were just opinions, protected by the free speech guarantees of the First Amendment to the US Constitution.
McGraw-Hill used the First Amendment defence in 1996 after its subsidiary S&P was sued for professional negligence by Orange County, California. S&P had given the county an AA-rating before it filed for the largest-ever municipal bankruptcy.
Orange County alleged in its lawsuit that S&P had failed to warn the Government that its treasurer, Robert Citron, had made risky investments with county cash.
The court ruled that the county would have needed to prove the rating company's "knowledge of falsity or reckless disregard for the truth" to win damages. It found that the credit rater could not be held liable for mere negligence, agreeing with S&P that it was shielded by the First Amendment.
Sharma says rating companies shouldn't be responsible when investors misuse ratings.
"Hold us accountable for what you can," he says.
He compares the rating companies to car makers. "Look, if you drove the car wrong, the manufacturer can't be held negligent. But if you designed the car wrong, then of course the manufacturer should be held negligent."
Sharma subsequently said his use of the car manufacturer analogy and the words "negligent" and "negligence" during an interview was a misstatement and does not reflect his or S&P's position.
"The point I was trying to convey is that the appropriate approach to accountability is through a regulatory process that requires [rating agencies] to adopt relevant policies and procedures and oversees their application," Sharma said.
The bigger issue is whether the credit rating system should be changed or even abolished. From California to New York to Washington, investors and regulators are saying it doesn't work. But no one has been able to fix it.
The federal Government created the rating cartel, and the US is as dependent on it as everyone else. So far, the legislative branch hasn't cleaned up the ratings mess.
"This problem really is like a cancer that has spread throughout the entire investment system," Partnoy says. "You've got a body filled with little tumours, and you've got to go through and find them and cut them out."
As the US has spent, lent or pledged about US$12.8 trillion in efforts to revive the slumping economy, and as President Barack Obama and Congress have worked overtime to find a way out of the deepest recession in 70 years, no one has taken steps that would substantially fix a broken ratings system.
If the Government doesn't head in that direction, all of its efforts at financial reform may be put in jeopardy by the one piece of this puzzle that nobody has yet figured out how to solve.
Ron Grassi says he thought he had retired five years ago after a 35-year career as a trial lawyer.