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A Reasonable Case For Regulation

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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.