Rating Agencies Take Due Fire 11 comments
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Yesterday's Congressional testimony was broken up into two sections, and it was clearly demarcated the good guys and the bad guys. The first group consisted of individuals either retired, let go or in direct competition with the Big Three rating agencies. These were men with axes to grind, and a vulnerable foe to take advantage of. The second group consisted of the CEOs of Standard & Poor's (NYSE: MHP), Moody's (NYSE: MCO) and Fitch. The three of them entered the room well-aware of the fire burning within its center, prepared minutes earlier for their roasting.
Over the past few months, the rating agencies have sort of been in hiding. Like the high school student who hadn't completed his report yet, they slid under their desks hoping to be overlooked or forgotten. S&P parted ways with the CEO who was in place when everything went down, perhaps in hope of sending blame off with her. However, she was not there when the first subprime loans were rated. In any event, concerned countrymen the nation over made sure the teacher didn't forget to call out their names.
The hands of the rating agencies seem as dirty as any in this mess, but because what they do is often misunderstood by Main Street, their directors and executives have been able to walk the street among their future hangmen. The same can't be said for the bosses of JP Morgan (NYSE: JPM), Bank of America (NYSE: BAC, NYSE: MER), Goldman Sachs (NYSE: GS) and others on Wall Street targeted recently by letters from angry citizens. S&P, Moody's and Fitch are not located on Wall Street, nor even associated with it. Neither are Fannie Mae (NYSE: FNM) or Freddie Mac (NYSE: FRE). As it becomes more clear whose really at fault here, the demise of those responsible firms seems likely. Oh, how angry the Congressmen were yesterday, and oh how easy they discerned fault, and oh how clear their plans seem.
The Inherent Problem
You can't provide an unbiased opinion when dollars are exchanged between the judge and the opined upon. Can you? You tell me. S&P, Moody's and Fitch get paid by the issuers whose credit they rate. Dennis Kucinich called that "criminal" on Wednesday. As hard as I was on Kucinich in my work on the passage of the bailout, if I lived in his district, I would no doubt vote for him. It's clear he cares more than most about his constituents, and takes his responsibility seriously. I believe he does his utmost to serve the little guy and the righteous cause always.
The inherent problem in this business model is that you can't serve two masters. The rating agencies pay the issuers, and at the same time, they serve all investors. But, if they're collecting payment from the issuers, well then, doesn't pleasing them become important also...
One of the Representatives said it best when he addressed the concerns of many of his constituents who lost everything they owned. He said that while they may not have understood some complex financial instruments or why everyone had a mortgage and a home, his constituents thought they understood what Triple A meant. An internal exchange of memos also indicated culpability, as it detailed the discussion of two employees of one of the agencies. One of them reportedly said to the other, on one hand, we would look negligent and on the other, we would look as if we had sold our souls to the devil. What he meant was, either they were negligent for missing the risk in these instruments or they were serving their paying masters, the issuers, with investment grade ratings they didn't deserve. If they were guilty of the latter, they violated their responsibility to investors across the world, and that would make them guilty of crime. If they simply made a mistake, well then maybe they're just not good enough to handle this responsibility. The fact that employees were talking about this seems to clearly indicate they knew what they were doing. Either way, the future does not look good for these firms.
The Bad Guys
The CEOs of the Big 3 entered with trepidation and gave addresses that might have been anticipated. First, they accepted that they failed in rating the securities in question incorrectly. As any PR man worth his pitch will tell you, when you get caught with your hand in the cookie jar, the best thing you can do is say, "I messed up."
"Sorry Charlie. Last I checked, being a part of the mob does not excuse individual crime."
Secondly, the chieftains of the three declared that they were, however, not the only ones to blame. It was as if they were seeking favorable adjudication on the basis of broader fault and dilution of blame. If there were others at fault, and they specifically pointed toward mortgage brokers, lenders, GSEs and one suspect you will not like. One individual had the gall to include investors for blame. In other words, the people who relied on their "expert" analysis were also expected to do their own credit research? How would you like it if an auto dealer sold you a car that became completely worthless after a short while, and then when you asked him about it, responded that you should have checked out the engine yourself. Where's the warranty in that? Why would anyone buy these things if the rating was assumed less than adequate? Sorry Charlie! Last I checked, being a part of the mob does not excuse individual crime.
The Good Guys
Sean Egan, Managing Director of Egan-Jones Ratings, an independent rating agency that earns its keep from institutional clients rather than the issuers it rates, found opportunity to shed light on the scars of his firm's rivals. He did so rather well, I might add. The lightness of his mood was in stark contrast to the utter fear one could sense from Fitch's chief as he spoke. Mr. Egan likely earned some new clients as a result.
However, we're not sure he realized that there's one scenario that threatens even his business. A Representative made note of how Congress is often guilty of first failing to anticipate crisis, and then equaling failing in overreaction to it. As far as I see it, there are two viable solutions to this problem, neither of which the ratings fat cats expect, but both of which should have a detrimental impact to their bottom lines. For this reason, I wouldn't in my wildest dreams think of owning shares of S&P, which is a subsidiary of McGraw-Hill (NYSE: MHP), Moody's (NYSE: MCO), nor any agency now.
Resemblance to Auditors
Aptly dubbed the Big 3 yesterday, the raters' title bore ominous resemblance to the Big Five auditors, who lest we remind you, were taken down and out after the last great regulatory debacle that allowed companies like Enron and Worldcom to commit crime. So, with fault seemingly clear, it seems likewise obvious that there are two paths forward.
The first path is to alter the business model that dictates the operations of the Big 3. All rating agencies would be required to operate like Egan-Jones, and no longer accept payment from issuers. However, in that case, we might leave too many financial instruments unrated. Well, the other option addresses that issue. In this case, we, the American citizenry, either take some or all of the responsibility of the rating agencies away. After all, it seems clear they failed us greatly. So, if anything should be government run, it seems rating securities (outside of sovereign debt) should be. Either of these options would likely leave these companies economically injured. We think for good reason though, don't you?
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This article has 11 comments:
Sean Egan presented his case effectively, but his objective, as far as I can see, is to create a climate of fear such that the only way a bond investor could feel secure would be by subscribing to his services.
I think the issuer pays model is economically more effiecient - the investor pays model would result in more fees overall and higher interest rates due to a higher risk premium required by those who couldn't afford to subscribe to a servcie.
But the industry needs to be heavily regulated, starting with a clear description of its role and responsibliity, and carefully defined minimum standards for ratings reviews. Tthere should be limits on their fees and a requirement that they do surveillance on issues they have rated. Rather than nationalize them, I would advocate removal of existing management and the installation of management that could adapt constructively to regulatory oversight.
Briefly, credit rating is affected with the public interest: it should be strictly regulated to ensure that it functions for the benefit of the nation as a whole, rather than management and shareholders.
> jack
BTW - Only 1 of the Big 5 Auditors went away - the other four got fatter and happier off Sarbanes-Oxley and the death of Arthur Andersen.