A Reasonable Case For Regulation

Before investing, you likely research the rating the financial product holds from one of the major credit rating agencies. But how would you feel if you discovered that a highly-rated bond received its grade, not because the company is strong, but because the rating agency:

1. assumed the government would bail the company out;
2. was most concerned with the "confidence sensitivity" of the market, so didn't tell investors that the company could soon collapse?

If you're like me, that would tick you off. Especially when you find out that those responsible for the shoddy analysis weren't disciplined but, instead, engaged in some "thoughtful soul-searching."

That is exactly what I was told, at a recent hearing of the House Financial Services Committee, by executives of the largest credit rating agencies - Moody's, Fitch and Standard & Poor's.

Credit-rating agencies were established in the 1920s as a safeguard for investors, who paid the agencies to evaluate bonds and provide unbiased ratings. In the 1970s, the Securities and Exchange Commission (SEC) turned the model on its head by requiring that bonds receive a rating prior to being sold. This meant corporations - not investors - were now paying the credit raters and turned the agencies' role from that of impartial consumer watchdogs into corporate marketing tools.

At a March hearing of the Oversight and Government Reform Committee, the agency executives asserted that consumers are still protected because the companies' reputations - and those of individual analysts - are on the line with each rating. So, having the opportunity to question them again, I asked Raymond McDaniel, Chairman and CEO of Moody's; Deven Sharma, President of Standard & Poor's; and Stephen Joynt, President and COO of Fitch; what repercussions befell those responsible for giving AIG and Lehman Brothers stellar ratings just days before they collapsed?

Here are some excerpts:

Me: After [AIG and Lehman failed] did you take any action against the analysts who had rated them? Did you fire them, suspend them? Did you take any action against those who had put that kind of remarkable grade on products that were junk?

McDaniel (Moody's): No, we did not fire any of the analysts involved in either AIG or Lehman.

Why?

McDaniel: An important part of our analysis was based on a review of governmental support that had been applied to Bear Stearns earlier in the year. Frankly, an important part of our analysis was that a line had been drawn under the number five firm in the market, and number four would likely be supported as well.

The same question was put to Mr. Sharma.

Sharma (Standard & Poor's): No, we did not fire anybody.

Me: No one got fired? No one got their hand slapped?

Sharma: Financial institutions are very confidence-sensitive. In Lehman's case, not only were they trying to raise capital, they were about to raise capital, and on the weekend they declared bankruptcy. And once there's a run on an institution, it's very hard to manage....

Then Mr. Joynt weighed in.

Joynt (Fitch): No, no analysts were fired. I would say that our lead analysts from those cases were disappointed, surprised, and went back and reflected on how [they reached their] conclusions. I think we've done a lot of thoughtful soul-searching...

State and local governments across the country lost billions of taxpayer dollars when their highly-rated Lehman Brothers bonds - part of safe and conservative investment strategies - became virtually worthless overnight. San Mateo County, California, lost more than $155 million to a fund that included school districts, cities and emergency services agencies. I doubt that the laid-off teachers and EMTs are overly impressed by Fitch's soul-searching.

So, who is to blame? The SEC has authority over credit rating agencies but, by all accounts, they've been asleep at the wheel. That is why, this week, the Financial Services Committee will consider legislation to restore confidence in our financial system and reassure American investors by strengthening and reforming the regulation of credit rating agencies. These reforms must:

• prohibit credit rating agencies from advising the companies they are paid to rate;
• require disclosure of all ratings a security receives so companies can't shop around for the highest grade;
• require the SEC to review how ratings are devised;
• require ratings agencies to disclose all information used in a rating, monitor its performance, and inform investors when a rating or assumption changes;
• hold rating agencies liable when they knowingly or recklessly fail to reasonably investigate a rated security.

We think nothing of protecting consumers from faulty toasters or unsafe cars. Is it unreasonable to suggest that investors are entitled to information they can trust before investing their hard-earned money?

I don't think it's unreasonable at all.

 

Comments

[sheaintsayin]

Rep. Jackie Speier: A true warrior for The People! Thank you, and please know we appreciate all your efforts and the great work you did for us in California with the banks!

[mjtaylor22]

PROTECTIGN THE CRIMINAL COMPANIEES INSTEAD OF THE INVESTORS.
so consumer credit agencies must protect corporations as well.
that is why it is so hard to get your score up

[Stephen Meli]

Uh, were the credit agencies wrong? Except for Lehman Bros., they correctly assumed that the companies would receive a bailout. Wouldn't the logical conclusion be to end the "too big to fail" myth and stop bailing out failed firms? Then company credit ratings would be in accordance with their actual market value instead of inflated by implicit government guarantees.

[research]

good article, keep explaining: "The greatest Heist in human history".

Regulate Fair market Capitalism is the great economic system ever created.

Unregulated markets and capitalism
are Rumors causing Panics. leading to crashes, massive poverty, and super concentration of wealth in a couple of hundred Robber Barons. see my profile for more background and links.

OUTLAW CDS.

[Prudens]

This could have been avoided if credit rating agencies knew with a certainty that these companies wouldnt be bailed out. No bail out. No inflated rating.

[Henry Mermet]

Dear Rep. Speier,
Thank you for publicising the dismal failure of the main credit rating agencies (CRAs); I hope you succeed in disseminating your views urgently in Washington, because at present it looks as if these uber-culprits are going to be left to walk away unscathed and on to bigger and better things.
One unaddressed problem today is that what CRAs did with sutructured subprime CDO's, they have often done before. Remember Penn Central? Orange County? Worlcom? Enron? Parmalat? etc.
And as I write, they are assigning investment grade ratings (which imply willingness to repay on the part of the issuer as per the CRAs' published rating methodologies) to sovereign issuers whom they know full well to be actively evading repayment of the full faith and credit obligations they owe to hundreds of thousands of defaulted investors throughout the world.
Who can ever trust CRAs who says China, or Russia, are willing to pay when they know these issuers remain in a state of unresolved default on prerevolutionary debt which it remains their liability to repay as per the successor government doctrine of settled international law?
Defaulted bondholders are considering RICO action against CRAs in the matter of voluntarily false and misleading sovereign ratings. For more on this please visit:
http://www.globalsecuritieswatch.org/Discussion_Brief_-_Civil_RICO_Complaint.pdf
and
http://www.archive-host.com/compteur.php?url=http://sd-1.archive-host.com/membres/up/203786733364141878/G20PREN.doc
and lastly
www.ccder.org
Thank you for your attention.

[overd0g1]

I would want the safety of the bond truly evaluated. That includes the probability of a bail out.

[TXfemmom]

All the rating agencies should be shut down, like Enron, and then a credit agency which is non-profit, and where individuals are on salaries and not permitted to even permit the companies they rate to know which employees were involved in their rating.

[overd0g1]

Why? Any investor that uses an ineffective ratings firm will lose money. When clients lose money, they stop patronizing the firm. When the firm has no clients, it goes out of business. When the government is ineffective, it doesn't go away, it just increases the budget. I'd stick with private ratings agencies.

[essbird]

Nice theory. Has it happened?

[dim]

Ratings companies would be remiss if they didn't take into account the probability of a bailout. What needs to stop are the bailouts.

[overd0g1]

Correct.

[Carl Caroli]

Ultimately, it's the ratings agencies that caused most of the heart ache. Their at best sloppy, at worse intentionally misleading AAA ratings of collateralized mortgages led to pension funds investing in high risk obligations and losing peoples futures. I would never trust any of them again.

[overd0g1]

And that is how the system corrects itself.

[nexxtep54]

The best case for regulation is to look at which economies suffered the greatest or the least during this latest upheaval. The more regulated , the least negative effect and the faster the re-bound.

[NeoconGal]

It's been said before and it needs to be said again. Ratings Agencies are nothing less than insider traders. They should be made illegal.

[overd0g1]

Who would use a ratings agency that was known to be lying for it's own enrichment? Nobody.

[grateful4thedead]

Jackie....nicely done.

contact zerohedge dot com that is where all the undersides of the cheat street beast are exposed.

[Hiphopcrates]

Jackie,
What you propose is not unreasonable, it is the bare minimum! Why hasn't the SEC been turned out and completely replaced. If my actions were responsible for the loss of income and equity of my employer, you know what line I'd be on every week.
When will the Fed be audited? Why are the usual suspects still in charge at Treasury and the Fed. How stupid does Congress think we are? Must we riot to receive consideration?

[Nosybear]

Any profit-maximizing corporation serves whomever pays it, in this case, the companies issuing bonds. All you need to do to determine what a company or a congressman will do is do a thorough analysis of their actual customers' needs. Most companies' customers are the shareholders, not the people buying the product or service. That's why airlines treat their "customers" so badly - the customers are the people cashing dividend checks or trading shares. Likewise, a thorough analysis of a Congressman's constituents shows clearly why he or she votes the way they do. They vote in favor of the ones who keep them in office through our perpetual election cycle, the donors and lobbyists. The voters are like the airline customers - treated badly while the actual customers make out like bandits. My solutions? Tax the hell out of dividends and capital gains (to make them less attractive), get shareholders out of corporate operations and to make it illegal for a Congress-critter to take a donation, a flight, a dinner or anything else from anyone other than the Federal government. And support elections publicly. Then you move the power where it belongs, with the Customer.