It's Not Rocket Science

I am not an economist (some might say that's a good thing). Yet I do understand some basic economic truths. One of them is the notion of incentives and how they affect behavior (human or otherwise).

Simply put, if people are rewarded in some meaningful way for doing one thing instead of another, then many, if not most, will respond accordingly. That is why, for example, stockbrokers who get paid on the basis of turnover will -- you guessed it -- encourage clients to trade. Or why a real estate broker generally won't tell you that buying a home now is a bad idea. Or why a car salesmen is happy to sell you whatever he has on the lot -- even if it's the wrong vehicle, the wrong price, or for the wrong reasons.

In other words, figuring out why people do at least some of the things they do is not exactly rocket science. With that in mind, is it really all that hard to understand, as TheStreet.com's Nat Worden reports, "Why the Ratings Agencies Flunked"?

Editor's note: The credit markets have been the epicenter of volatility on Wall Street throughout the second half of 2007. Falling home prices and subsequent defaults on mortgage-backed securities led to a liquidity crisis that's expected to get messier in 2008. The outlook for companies in the financial sector and beyond is dim as corporate profits weaken amid a weakening economy and rising inflationary pressures. This is the fourth installment in an ongoing series about how the tumult in the credit markets will affect the economy and the markets in 2008. Earlier stories looked at mortgage lenders, banks and brokerages.

Here's a New Year's resolution for Wall Street: Stop letting credit ratings agencies get paid by debt issuers for grades that can make or break their products.

In the mortgage debacle that plunged U.S. financial markets into crisis last year, there's no shortage of culprits. Snake oil-selling lenders, naive borrowers, delusional investment bankers and snoozing regulators all fit the bill, but the major credit rating agencies stand out as the chief enablers.

Blessed by government regulators with their unique and exclusive authority, the ratings firms institutionalized the notion that securities backed by subprime loans were basically risk-free.

In other words, rather than fulfilling their proper role in the market by warning investors about the obvious risks involved in these securities, they instead opened the floodgates to all those bad actors and created a systemic problem.

Why did the credit ratings agencies fail so spectacularly? There's one simple reason: They were paid handsomely for their stamp of approval by the very financiers who were packaging up the bad loans and selling them around the world.

Moody's Investors Sue Over Subprime

"It's as if movie studios hired film critics to review their movies, and paid them only if the reviews were positive enough to get lots of people to see a movie," former Labor Secretary Robert Reich wrote on his blog. "The whole thing rested on a conflict of interest analogous to that of stock analysts who, before the dotcom bubble burst, advised clients to buy stocks their own investment banks were issuing."

Credit ratings agencies have acknowledged the potential for a conflict of interest in their business model, but have said they've taken strict measures to prevent such a conflict from ever taking root. They also acknowledge fundamental misjudgments on subprime debt issues, but say that in many cases, fraud was committed by borrowers and lenders.
Enron and WorldCom Were Red Flags

At the turn of the century, a bull market ended when a stock bubble burst and conflicts of interest for equity analysts were dragged into the limelight. This time around, a five-year bull market seems to have concluded with the bursting of a credit bubble, and credit analysts are in the crosshairs. That said, the fundamental flaw in how credit ratings work on Wall Street is hardly a recent epiphany.

The so-called Big Three ratings agencies -- Moody's Investors Service (MCO) , Fitch Ratings and McGraw-Hill's (MHP) Standard & Poor's -- held investment-grade ratings on Enron only days before the company filed for bankruptcy in 2001. They also missed the boat on WorldCom and other flameouts from that era, leading to a series of hearings on Capitol Hill that shed light on what Lawrence White, professor of economics at NYU's Stern School of Business, calls "the best-kept secret in Washington, D.C."

In the mid-1970s, the Securities and Exchange Commission established capital requirements for banks, insurance companies and other financial institutions. Those requirements would depend on credit ratings from firms designated by the SEC as Nationally Recognized Statistical Rating Organizations, or NRSROs, and Wall Street's Big Three ratings firms were immediately grandfathered in.

Over the next quarter-century, the SEC extended the designation to only a handful of additional firms. It never defined standards for the designation, and it never acknowledged the receipt of an application from other players.

"It was an exceedingly opaque approval process and an incredibly restrictive regulation for an important industry that created a barrier to entry and quite possibly affected the way the bond markets work," says White. "After all, the bond markets must pay attention to the NRSROs, because in addition to setting capital requirements, only their ratings will get a bond into a bank portfolio, so a good rating can dramatically raise demand for a bond in the market."
A Small Firm Provides a Model

Even as lawmakers became aware of this government-imposed oligopoly after the dot-com meltdown, they never got around to legislating on the matter until Congress finally passed the Credit Rating Agency Duopoly Relief Act of 2006, a bill designed to lower the barrier to entry and open up the NRSRO process to new firms that could increase competition.

Egan-Jones Ratings, a small but respected ratings firm that has been around for about 15 years, first applied for NRSRO designation in 1998, and was finally approved by the SEC on Dec. 21. Unlike the Big Three, Egan-Jones is paid for its ratings by investors -- not issuers -- and co-founder and President Sean Egan says it has made all the difference.

"It's lunacy to have a ratings system whereby the major ratings firms are paid by the issuers," says Egan. "The issuers' interests are diametrically opposed to the interests of investors, so the issuer-supported credit ratings agencies have no credibility in the market. There's no reason why all these structured finance securities were rated Triple-A. Those are false ratings, and it's becoming increasingly obvious as the mortgage crisis develops."

Egan has long been an outspoken critic of what he calls "the issuer-sponsored ratings firms." He says his firm's ratings will have more clout in the market with the new designation, and he points to his track record. Egan-Jones was well out in front of the Big Three in issuing downgrades on Enron and WorldCom. Then, it was far ahead of the pack on the auto industry's woes, with early downgrades on General Motors and Ford (F) ; it also was out front on the collapse of homebuilders like KB Homes (KBH) and Pulte Homes (PHM) .

In a study on ratings performance conducted in 2003, the Federal Reserve concluded that "overall, it is robustly the case that Standard & Poor's regrades from BBB- moved in the direction of Egan-Jones Ratings' earlier ratings. It appears more likely that this result reflects systematic differences between the two firms' rating policies than a small number of lucky guesses by Egan-Jones."

A subsequent study by Stanford University and the University of Michigan said, "we believe our results make a strong case that the non-certified agency [Egan-Jones] is the leader and the certified agency [Moody's] is the laggard."

Egan gets the most publicity for his negative calls, but he claims he's also ahead of the curve on positive calls, noting that until eight months ago, most of his ratings were higher than S&P and Moody's.

Bill Ackman, a hedge fund activist with Pershing Square Capital, named Egan-Jones as his ratings firm of choice when he recently presented his controversial prediction at an investors conference in New York that bond insurer MBIA (MBI) could go bankrupt by the second quarter of 2008.

Ackman famously released a report questioning MBIA's Triple-A credit rating in late 2002. In 2007, shares of the bond insurer dropped 70% on credit worries, and on Dec. 20, the company revealed that its total exposure to bonds backed by mortgages and collateralized debt obligations is about $30.6 billion.

The major ratings agencies just recently put the company on negative credit watch, signaling a downgrade. As the largest insurer of muni bonds and other types of financial products, MBIA is at the heart of the country's financial system, and its deterioration threatens to have far-reaching effects on the economy.
Barrier to Entry High

Egan-Jones beat the big guys across the board on the bond insurers and the subprime mess, and Ackman attributed its superior performance to its business model. That said, he questions whether the firm, even with its new designation, will ever compete with the major ratings agencies. With around 20 employees and just over 400 clients, Egan-Jones focuses on corporate credit, issuing ratings on around 1,250 companies that each have more than $100 million in outstanding publicly traded debt. Egan declines to provide annual revenue and earnings figures, but he says the firm is profitable.

Moody's, the only publicly traded ratings firm, posted net income of $705 million in 2006, up 343% from the $159 million it reported in 2000. That gain stems largely from increased fees from the "structured finance" products that are now at the root of the credit crisis. Meanwhile, it boasts some 9,300 customer accounts at 2,400 institutions around the globe and has more than 1,000 analysts.

Ackman says it's tough to support a sizable ratings business while being paid only by investors, because once a bond is determined to be Triple-A, everyone can use that rating without paying for it.

"What they should do is charge the issuers a few basis points on every bond for the ratings and those funds should go into a pool to pay firms that provide ratings," says Ackman. "Investors should determine how those funds get allocated on an annual basis by using surveys to select firms with the best track record."

Egan points out that the major credit ratings agencies all survived for more than a half-century on fees paid by investors. It wasn't until the 1970s that they shifted their business to issuer-backed models.

"Our business model makes a lot of sense and it has worked beautifully in the past," says Egan. "Eventually, ratings firms should be weaned from issuer compensation if they're going to be considered designated ratings firms by the SEC."

Comments

[Independent Accountant]

I have been battering the rating agencies on my own blog for months. It seems Egan may be the only rater out there with any brains and integrity.

[A. Zarkov]

Anyone who remembers the Orange County debacle in 1994 should have known not to trust the ratings agencies. Just a few months before OC went bankrupt they got high ratings. Of course it was obvious that the OC portfolio was a bet on the direction of interest rates, and a CPA who ran against OC Treasurer Citroen said so. He also predicted they would lose over a $billion, and they did. When confronted with their ratings one spoken responded: “we evaluate credit risk, not market risk.”

[needles]

There's nothing new about any of this information. It's just now people are now beginning to talk about it openly. Frank Partnoy (Former derivatives trader at Morgan Stanley and author of "Infectious Greed" and "F.I.A.S.C.O") wrote a longish paper on the ratings agencies and what a joke they were back in 1999. What he wrote eight years ago has now become common knowledge from lessons that many learned the hard way.

A few excerpts:
THE SISKEL AND EBERT OF FINANCIAL MARKETS?: TWO THUMBS DOWN FOR THE CREDIT RATING AGENCIES
http://law.wustl.edu/WULQ/77-3/773-619.pdf

The theory of why a CBO works is that the sum of the parts is greater than the whole.
In a competitive, efficient market, CBO transactions should not be possible.Put another way, the fact that CBO structurers make money is evidence of market failure of some type. CBO structurers appear to be able to make money from these transactions because either (1) high-yield bonds are systematically underpriced, because market segmentation limits the demand for these bonds, or (2) the methodology the credit rating agencies use to rate bonds issued by the CBO vehicle is misguided and allows the creation of a greater whole from the sum of the parts, despite the absence of any conceivables ynergy. Again, there is little empirical or theoretical support for (1), and (2)contradicts the reputational capital view.
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[SIVs] invest mainly in sovereign bonds, bank debt, and asset-backed securities. Clarke has stated: "We are probably overweight in ABS, but where else can you invest in triple-A rated securities with a stable cash flow and a reasonable spread?" This statement and the very existence of these vehicles support the argument that credit ratings provide something other than accurate information.
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The notion is that a careful quarterly presentation to the agencies can present a rosier picture of that issuer than is really the case. The fact that the most sophisticated market participants are formally planning quarterly "window dressing" for the agencies indicates that such agencies can be duped, and probably are. The potpourri of new rating-driven transactions supports this conclusion.
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In sum, the above discussion has demonstrated that the three criteria that must be satisfied for rating certification to be credible are not satisfied for credit rating agencies. First, rating agencies have little reputational capital at stake in the certification activity; they can maintain whatever credibility they need by parroting market price moves. Second, the gain from inaccurate certification vastly exceeds the cost of any loss in reputational capital. (This is especially true if agencies are able to persuade investors that ratings are valuable information because they are correlated with actual default experience.) Third, the agencies' services are not costly; it is cheap and easy to follow market events and adjust ratings after the fact. In modern financial markets, the information asymmetries that generated the need for ratings in 1909 are long gone.

[A. Zarkov]

needles:

Thanks for the article. I learned about OC from Partnoy's book FIASCO. His second book Infectious Greed was even better. Moodys, S&P and Fitch will make a silk purse out of a sow's ear anytime. The whole situation is a scandal. Recent research shows that humans are hardwired for optimism, and an optimistic attitude gets rewarded. Look at Larry Kudlow. He has a TV show, but in my opinion he is a complete idiot on things economic and financial.

[needles]

A. Zarkov:

If you liked Partnoy's books you might want to check out - if you haven't already - Satyajit Das's "Traders, Guns, and Money". Covers some of the ground as "Infectious Greed" but written in a very entertaining manner. There are some snide and snarky comments that are hilarious.

Yes, the whole situation is a scandal. But as you could extrapolate from "Infectious Greed", it was pretty much inevitable.

[Rocky]

If issuers did not pay for ratings, who would? Rating agencies are not charities. It's a lot easier charging one issuer $50,000 for a rating than 5,000 buyers $10 each. In heaven, all things will be perfect. But we live on earth, not in the hereafter.

Maybe some of the blame should go to big institutional buyers who skimp on buy side research, preferring to rely on the rating agencies and the brokers for most of their research. Buy side credit analysts tend to be rather poorly paid, by Wall St. standards and often do trading and portfolio management at the same time.

[A Gupta]

Very informative comments. But looks like nothing is going to change. Only thing SEC is going to do is bring in more NRSRO - they are planning to have total of SEVEN (currently we have 4 including Egan - 3 more to come). Any guesses who will be the lucky 3 ?

[A Gupta]

Pardon my ignorance (my last comment above). There are already 8 NRSROs (including Egan) - Standard & Poor's, Moody's Investors Service, Fitch Ratings, Dominion Bond Rating Service, Japan Credit Rating Agency, Ratings and Investment Information, A.M. Best and Egan Jones.