Greenspan: Rating Agencies Major Factor in Crisis

At a congressionally appointed panel investigating the causes of the financial crisis, Former Federal Reserve Chairman Alan Greenspan criticized credit rating agencies for doling out high marks to securitized subprime mortgages, inculpating them for their role in creating the current financial crisis.

“All I will say is what I can say for myself, [which] is that the ratings that were developed by the credit rating agencies were a major factor in the cause of the problems,” he told questioners.

Many fingers have been pointed at credit rating agencies for the top grades they assigned to securities based on subprime mortgages that then ran into repayment problems or defaulted.

However, this is a mistake. There were bad bonds and bad structures. But the rating system downgrades were driven by what the ratings measured: the first dollar cost. By the way, don’t investors bear some responsibility for their own investment decisions?

Corporate Scorecard Gets Green Light

Corporate Scorecard (CSC) has joined Australia’s credit ratings market after getting the official go-ahead from Australian Securities and Investment Commission (ASIC) to operate as a licensed credit rating agency.

The company joins Standard & Poor’s, Moody’s Investors Service and Fitch Ratings as credit rating agencies licensed by ASIC. Says General Manager Brad Walters, “CSC has invested heavily in fulfilling all of the regulatory requirements and ongoing monitoring obligations.”

Corporate Scorecard is paid by clients such as governments, companies and investors to assess the risk of counterparties, rather than by issuers to rate the securities they are selling.

“Whether it’s a wholesale investor looking at a particular issuer, or a government department assessing a particular company, they are our client and so the remuneration line for us is direct to them,” said Walters. “Therefore, we don’t have that inherent conflict of interest of being paid by the issuer.”

CSC is the first Australian-owned credit rating agency to obtain an Australian Financial Services License to provide credit ratings. Operating at various levels within government and private sector, the company has been in business since 1987.

Hooray for the free market! A “new” rating agency, with a new pay model emerged from the wreckage. No government subsidy, legislation, government ownership was needed.

Financial Reform Bill May Skirt Debate

Senator Christopher Dodd (D-CT) is maneuvering the financial reform bill to go straight to a vote in late April without any floor debate. As the most ambitious financial reform proposal since the Great Depression, the move to ignore more than 400 proposed amendments has provoked criticism.

Republicans, who are traditional supporters of the free markets that would be adversely affected by many provisions in the bill, are in a difficult position. To fight the bill “on behalf of the banks” could result in voter backlash. There is widespread public support for strengthening banking regulations. To allow it to go forward without challenge would be to abandon their traditional supporters.

The bill is also open to opposition from some Democrats who don’t feel that new regulations are tough enough.

As for how the bill affects credit rating agencies, Senator Bob Corker (R-TN), a member of the Senate Banking Committee who has been working closely with Senator Dodd to craft the bill, commented that the proposed new regulations had not changed from Dodd’s original plan. He said that the bill placed a “pretty big liability burden” on the rating agencies. Generally, Republicans are opposed to this increased risk of litigation. They argue that it will result in frivolous and expensive lawsuits that would serve no good purpose. But the challenge remains:  How can they frame this debate without angering the voter base?

Asian Ratings Agencies Suggested

Asian financial writers are challenging the new rating agency regulations being proposed by the Chairman of the Senate Banking Committee, Christopher Dodd (D-CT) and similar moves by European regulators. The writers argue that nothing is being done to address the fundamental conflict of interest inherent in the agencies’ business model.  The issuers of the bonds being rated also hire and pay the agencies.

They also note a second conflict of interest. The U.S. and other heavily indebted governments do not want to reform the credit rating agencies because of their own borrowing needs. They could be exposed to potentially expensive downgrades if “true” credit ratings become the industry standard.

Instead, given the vast U.S. and European government debt that is held by Japan, China, South Korea, India and other Asian countries, they argue that it is time that Asians created their own assessment of the true creditworthiness of Western nations.

This agency or agencies would effectively replace the existing three major American agencies.

The Asian countries have another worse option: Stop buying our bonds.

Articles Praise Timothy Geithner

Treasury Secretary Timothy Geithner has been widely criticized for his handling of the financial crisis and the Wall Street bailout. However, profiles in The New Yorker and Atlantic Magazines, attribute the economy’s turnaround, as modest as it has been, to Geithner.

Both pieces maintain that Geithner is a deft technocrat who was able to avoid the nationalization of banks and save the U.S. taxpayer trillions.

Yet Joshua Green of Atlantic believes that Geithner was a product of the pre-crisis Washington:

Everyone thought that financial services was the perfect industry, where you had a harmonization of progressive values with money. It was a way to be a good Democrat and a good liberal while making lots of money. The mark-to-market accounting changes, the loosening of bank capital requirements, harmonizing international standards—all that stuff was seen as, like, ‘Where’s the harm in this?’ If banks are making a little more money to keep up with their international competitors, what’s the big deal?

Geithner, Green concludes, was able to quickly see “the big deal” when things began to implode and attributes his actions to saving the economy.

John Cassidy of The New Yorker, gives credit to Geithner for restoring faith in the banks and is critical of the Obama administration for providing Geithner with insufficient support and Presidential leadership.  Time Geithner is a bit real player in this crisis.  He has addressed the symptoms.  The real investigation and some blame should be aimed at Congress, FNMA and Freddie Mac.  Until we call out Congress and the GSEs, we will be doomed to repeat this crisis.

Dodd’s Bill Allows Credit Rating Agencies To Be Sued

Senator Christopher Dodd’s (D-CT) financial industry regulation reform bill was rolled out without too many surprises. However, the bill does include a provision that would, for the first time, allow credit rating agencies to be sued for “a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.”

Deven Sharma, president of Standard & Poor’s, voiced two objections to the draft legislation.  He maintains that the agencies would be subjected to new discriminatory liability standards that would not apply to other market participants, such as accountants and security analysts. This, he argues, could lead to frivolous lawsuits, limit access to capital and delay a full economic recovery.

Second, Mr. Sharma maintains that the language encourages lawsuits against rating agencies whenever ratings change. The bill ignores that ratings may change because of “unforeseen economic developments, technological advances, new regulations or management changes.” In an opinion piece in USA Today, Mr Sharma writes, “Investors want rating agencies to provide updated analysis, and this provision would hamper their willingness and ability to do so.”  Dodd should pull this provision.  Sharma is right.  Investors don’t have to listen to S&P.  This will open the lawsuit floodgates on the NRSROs.  If Dodd wins, ratings will be so cautious as to be valueless.

Edward Altman Launches Rating Tool

Default expert Edward Altman has teamed with RiskMetrics Group to offer credit ratings on North American companies. Altman will initially be rating approximately 2,600 U.S. and Canadian companies with sales of $50 million or more.

“We are excited about it being a significant improvement over existing models that are out there and providing probability of default estimates that are very important to investors,” Altman is quoted by Reuters. Altman maintains that the new venture will not compete directly with traditional rating agencies like Standard & Poor’s, Moody’s or Fitch.

Rating agencies evaluate companies based on their probability of default. Instead Altman’s tool produces a precise default probability in percentage terms over one- and five-year periods. These probabilities are calculated using a “Z-Metrics” credit analysis tool, a new generation of the Z-Score originally introduced by Altman in 1968 to predict corporate defaults.  Hooray for Altman.  Let’s have the market decide if his business has value.  The market produces solutions to problems in time, if Congress doesn’t impede progress.  Let’s hope the financial reform doesn’t kill this business.

“The accuracy level in terms of predicting defaults and non-defaults is considerably higher than both rating agencies and the old Z-score models,” Altman said.

Portugal’s Finance Minister Blames Ratings Agencies

Fernando Teixeira dos Santos, Portugal’s finance minister was critical of the international credit rating agencies for damaging his country’s economy. He is saying that the risk assessments being made are mistaken.

The Financial Times reports him saying, “Many of the problems we face are related to errors in risk evaluation that have been made, in part, by the rating agencies… We cannot be subject to the commercial strategies [of rating agencies] whose objective may be to increase their market share.”

He went on to say that it was “paradoxical” that the rating agencies (and others in the banking and business communities) had appealed to governments to support economies at the height of the global crisis. Now, however, these same players are insisting that states rapidly consolidate their deficits.

Three credit rating agencies have recently warned that Portugal’s sovereign debt faces downgrading if it should fail to take steps to lower its budget deficit.  That deficit is now at a record 9.3 per cent of gross domestic product in 2009. In contrast, the U.S. 2009 deficit is projected to be 12.4%. of GDP.

Portugal’s long-term debt rating currently ranges from Aa2 at Moody’s to A+ at Standard & Poor’s. Spain and Greece’s credit ratings have also been threatened by their respective deficits forced by the worldwide economic conditions.

A Good Idea

Representative Paul Kanjorski D-PA has proposed that the federal rule be dropped that requires credit ratings to determine what an asset is worth, and therefore determine capitalization. Representative Kanjorski’s intent is to distance the Federal Government from a de facto endorsement of ratings agencies’ work. In its own right, this is a worthy goal.

But dropping this rule, which dates from the Great Depression would have a far greater consequence. The unanswered question is: What will replace NRSRO ratings.

Although a good move, this rule change is still nibbling around the edges of the reform that’s needed at the ratings agencies. Until the business model is changed so securities issuers are no longer paying for their own ratings, the value of those ratings will be forever suspect.

Mission Impossible

The unworkable environment in which ratings agencies function is slowly coming to light.

It was discovered that while Goldman Sachs was selling $40 billion in securities in 2006 and 2007, backed by at least 200,000 risky home mortgages, they were secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting.

Goldman Sachs maintains that they were merely managing risk and had no disclosure burden under the Securities Act of 1933.  Maybe so, maybe not.  That is for the lawyers and courts to decide.

Nonetheless, it gives one pause when putting this issue into the context of a rating agency.  How incredibly difficult it must be to assess a security given the initial paucity of information, the underwriter’s efforts to keep as much information buried as possible, and the pressure from the rating agency’s internal organization (tacit if not overt) to give clients high ratings.

For rating agencies to be effective again, they need greater access to information, they need to be free of conflicts of interest, and they need regulation to ensure they get both.

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