New Amendment Targets Rating Agencies

Senators Al Franken (D-MN), Charles Schumer (D-NY), Bill Nelson (D-FL) and Roger Wicker (R-MS) have proposed an amendment to dismantle the “issuer pays” model that rating agencies currently use. The amendment would establish a Credit Rating Agency Board that would arbitrarily choose which rating agency would rate an issuer’s debt.

Taking aim at what they call a “permanent conflict of interest,” proponents of the amendment argue that this would make it more impartial as well as open up competition to smaller firms. The bipartisan proposal has received widespread support, including the endorsement of the Consumers Union consumer advocate group.

The rating agencies have unanimously come out against the amendment. “We believe the benefits of the issuer-paid model, combined with appropriate regulation, can far outweigh any potential conflicts of interest,” said Standard & Poor’s spokesman Ed Sweeney.

This is a bad idea (how come every problem can be solved with more government?). The only guys in America who didn’t know or understand this conflict existed were Franken, Schumer, Wicker, and Nelson. The new Board name should be aligned with the usefulness of the idea: Credit Rating Agency Panel.

France Blames Ratings Agencies for Aggravating Greek Credit Woes

Rating agencies have successively downgraded the sovereign debt of Portugal, Greece and Spain and this has, in part, led to a sharp devaluing of the euro. The European Union has protested that the lower ratings assigned to Greece, in particular, ignore the fundamental indicators of the Greek economy as well as the aid plan created by the euro zone and the International Monetary Fund.

When speaking on French radio Europe 1, French Economy Minister Christine Lagrade said that France will reinforce control over the rating agencies. “I think certain rules should be fixed … because we don’t degrade a country under the conditions that its rating has been degraded, that’s to precipitate purchases of sales 15 minutes before the close of trading, deplorable for the solidity of the market,” she explained.

In an interview with Le Monde, she also said that the downgrade 15 minutes before markets closed was “crime inducing” because it created a panic among those holding Greek bonds who thoughtlessly offloaded the investments before markets closed, driving values down even further.

Previous European Commissioner for Internal Market Regulation Michel Barnier expressed the opinion that rating agencies should be “disciplined and responsible in their evaluation process.” Mr. Barnier, also of France, had also mentioned that the European Union was considering creating Europe’s own rating agency to balance the valuation opinions of the American agencies.

Vive la France! This is like blaming the thermometer for the heat.

Buffet Defends Rating Agencies

Speaking at Berkshire Hathaway Inc.’s annual meeting, Chairman and CEO Warren Buffett defended the company’s maintenance of its stake in Moody’s Corporation.

Mr. Buffett said rating agencies “made the same mistake” that everyone else did in overvaluing the health of the housing market. However, he countered, Moody’s — as well as McGraw-Hill, Standard & Poor’s and Fimalac SA’s Fitch Ratings — possess strong pricing power and require little in capital needs.

“There is obviously a backlash against rating agencies,” he said. “If they are not forced to change the whole structure around them … in some dramatic way, [they are still] a pretty darn good business.”

Mr. Buffett also pointed out that Berkshire has “never paid any attention” to credit ratings for bonds. “We don’t think we should farm out — outsource — investment judgment,” he said.

Rating Agencies Point Out Catch-22

The investigations on Capitol Hill have turned to how the rating agencies publicly shared the computer models they used to devise ratings. Ostensibly, the practice ensures that banks and other issuing bonds aren’t surprised by a weak rating that can adversely affect their ability to sell. What the Senate Panel took issue with is how it opened the door for bankers to work backwards: tinkering with complex mortgage deals until the model delivered the desired rating.

David Weinfurter, a spokesman for Fitch Inc., defended his company by saying it had made its models public in response to demand for increased transparency. He also pointed out that a committee, not the models, ultimately assigned ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.”

Angelides Backs Senate Ratings Clearing House

Phil Angelides, chairman of the Financial Crisis Inquiry Commission, said that he supports a provision included in a Senate-approved bank reform bill that creates a government clearinghouse for structured-finance products that need to be rated.

An investment bank that needed a rating for a structured mortgage product, for example, would submit a request for a rating agency to the credit board.  The board would then assign which rating agency would do the work.

The idea has been controversial. The goal is to break up the cycle of credit rating agencies providing inflated ratings to get repeat business. Opponents object to the intrusion of government and its bureaucracy into the ratings process and claiming that the process would still not necessarily lead to more accurate ratings.

A government ratings assignment board would slow down credit formation and make it more expensive. All market participants know that issuers “shopped” ratings. This is only news to D.C. The government ratings assignments will only slow down the process, for the worse.

EU Revises Rules on Rating Agencies

The European Commission has suggested a list of revisions to EU rules on credit rating agencies that would increase transparency and centralize European supervision. Should the proposals be enacted, the European Securities and Markets Authority (ESMA) would take over the supervision of rating agencies in Europe from national authorities. The ESMA is a new entity whose legislation is still being negotiated by member states and the European Parliament.

Commission President Jose Manuel Barroso has stated that a European credit rating agency is another possibility. “We are looking at the idea,” he said. “Is it normal to have only three relevant actors on such a sensitive issue where there is a great possibility of conflict of interest? Is it normal that all of them come from the same country?”

Any proposals along these lines are not expected before September.

Bad idea. Leave credit evaluation to the market participants. Eliminate NRSRO designations. Ban governmental endorsements of rating agencies. Delete the use and reference to ratings.

Buffett Testifies Before FCIC

Warren Buffett recently testified before the Financial Crisis Inquiry Commission (FCIC) alongside Raymond McDaniel, the CEO of Moody’s Corporation.

Apropos of the report that 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have now been downgraded below investment grade to junk status, the Commission asked Buffett what he thought of the provision in the bank reform bill that would regulate rating agencies.

Buffett responded that while he “hated” the current system, he wouldn’t go so far as to outright support the measure. “I don’t know the answer to that,” he said. “The wisdom of somebody picking out raters, is that going to be perfect? I don’t know.”

He added that, “When rating agencies come to Berkshire, they have me by the throat. I have no leverage whatsoever. If there were 10 agencies and I took the cheapest one, people would say ‘You took the cheapest, but they didn’t do the work,’ so it’s not an easy answer.”

Buffet’s testimony can be seen at: http://www.cspan.org/Watch/Media/2010/06/02/HP/A/33689/Financial+Crisis+Inquiry+Commission.aspx

Senate Subcommittee focuses on Moody’s and Standard & Poor’s

The Senate’s Permanent Subcommittee on Investigations has uncovered Moody’s and Standard & Poor’s employee emails that call into question the legitimacy of their AAA ratings that were given to hundreds of billions of dollars’ worth of subprime mortgage-backed securities that have now been downgraded to junk status.

Paul Krugman, writing in The New York Times, believes that those emails reveal a deeply corrupt system.

In one email, a Standard & Poor’s employee explains that they needed to “discuss adjusting criteria” used to evaluate housing-backed securities “because of the ongoing threat of losing deals.”  Another regrets needing “to massage the sub-prime and alt-A numbers to preserve market share.”

The emails leave little doubt that the inherent conflict of interest in the rating agencies’ business model impacted risk assessments. Consequently, the financial system unknowingly took on more risk than it could responsibly handle.

No legislation is currently being considered to regulate this activity.

Moody’s Cooperates with Financial Crisis Panel Subpoena

Moody’s Corporation began handing over documents one day after the Financial Crisis Inquiry Commission issued the company a subpoena for failing to comply with requests for documents. Moody’s missed a March 23 deadline to release documents that the panel requested months earlier.

The panel’s chairman, former California state treasurer Phil Angelides wouldn’t specify what the documents were, stating only that they were “essential documents and emails relevant to our investigation.”

The commission had cause to worry about how quickly documents were supplied: They only have until December 15 to complete their investigation and report on the causes of the financial crisis.

Moody’s said in a statement that it “continues to devote substantial resources to producing documents and making our people available” to the committee.

Former Employees Speak Out Against Rating Agencies

Former executives at Moody’s Investors Service and Standard & Poor’s criticized the firms at a hearing before the Senate Permanent Subcommittee on Investigations. They testified that the companies allowed a competitive culture and conflicts of interest to compromise their ratings of complex securities.

“It was an unspoken understanding that loss of market share would cause a manager to lose his or her job,” said Eric Kolchinsky, a former managing director at Moody’s. He said that he was suspended after warning in September 2007 that a batch of securities “being hyper-aggressively pushed by the bankers” had been assigned an inflated rating.

Several current managing directors also testified, including Kathleen A. Corbet, who was president of Standard & Poor’s from 2004 to 2007; and Raymond W. McDaniel Jr., the chairman and chief executive of Moody’s.

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