Obama’s Bank Tax Draws Fire

Senator Judd Gregg, (R-NH) who is working with Senator Jack Reed (D-RI) on regulation of derivatives and credit rating agencies, criticized President Obama’s proposals to tax and curb Wall Street’s activities, calling the bank tax a political response to losing the Massachusetts Senate seat.

“I think it’s confused the issue considerably, because he’s basically fanned the fires of populism and in a lot of instances, populism doesn’t give you either good regulatory activity or strong markets,” Mr. Gregg said. “It undermines both, in many instances.”

But industry representatives and Democratic Congressional aides have countered, saying that the president’s new proposals have dialed up the energy and volume of the lobbying on regulatory reform, a sure sign that things are moving along.  One thing is for sure: vengeance makes bad tax policy.

Federal Judge Dismisses Suit Against Moody’s and Standard & Poor’s

U.S. District Judge Lewis Kaplan dismissed claims against Moody’s Corp and Standard & Poor’s in litigation over nearly $100 billion of Lehman Brothers Holdings Inc. mortgage-backed securities.

Investors had accused the agencies of having misled them by disregarding ratings guidelines and having a conflict of interest. They claimed that the agencies had rated mortgage-backed securities that they had helped to create and structure.

Reuter’s news service quotes Joshua Rubins of Satterlee Stephens Burke & Burke LLP, the law firm representing Moody’s, “The judge has obviously agreed with the arguments that we made that the ratings agencies have never been held to be potential defendants under these provisions and it was a distortion of the statute to try to bring claims against the ratings agencies.”

The judge’s rationale is not yet available. A written ruling is expected.

Ratings Agencies Announce Higher Than Expected Profits

Credit rating agencies Standard & Poor’s and Moody’s are widely criticized for assigning high ratings to investments, particularly mortgage-backed securities, that later proved to be of poor quality. They are widely blamed for disserving investors.

Despite the damage done to their reputations, as the economy recovers, the credit rating agencies’ fortunes are reversing. Bond sales surged 41% to $1.2 trillion in 2009 as companies rushed to take advantage of loosening credit markets. As a result, the demand for ratings has also significantly increased so the ratings agencies have delivered solid operating results.

Moody’s fourth quarter income was reported at $101.9 million, 42 cents a share, which came in ahead of expectations. Similarly Standard & Poors’ owner, McGraw-Hill, reported earnings of 51 cents a share — far ahead of the 40 cents per share that was expected. Contributing to the profit surge was that revenue in their credit markets services group grew by 19%.

Ratings Agencies Relied On Bad Information from Freddie Mac and Fannie Mae

Peter Wallison, a Treasury Official in the Reagan administration, wrote in The Wall Street Journal that Edward Pinto, former Fannie Mae credit manager, discovered that both Fannie Mae and Freddy Mac routinely exaggerated the quality of its mortgages. Mr. Pinto explains that Alt A and subprime mortgages were routinely rated as “prime” to make mortgage credit more readily available to lower income levels.

Because of this misrepresentation, the ratings agencies believed that losses from the securities backed by these mortgages would be “within the historical range for the number of high-risk loans known to be outstanding.” Instead the number of high-risk loans was much larger than anyone knew. When the default rates and losses exploded, Mr. Wallison explains, the subterfuge was exposed, leaving those holding the assets — and the ratings agencies — wondering what happened.

Therefore, the fault for the collapse, Mr. Wallison maintains, was not Wall Street’s or the ratings agencies’, but the misreporting that distorted the perception of everyone who bought and sold securities backed by these mortgages. This misreporting, he believes, was in response to government affordable housing rules. “Fannie Mae and Freddie Mac are inexorably intertwined in the market collapse. It is essential that any examination of the crisis begin with a review of Congress’s use of Fannie Mae and Freddie Mac. We won’t hold our breath.”

Proposals Pending to Eliminate Ratings’ First Amendment Protection

The free speech provisions of the First Amendment currently protect rating agency opinions. Although in the past the agencies have been sued for ratings given to investments that did not meet stated objectives, the agencies have never been found liable. This is because the burden of proof is the same as for libel. The plaintiff must demonstrate malice. Suggested legislation, proposed rule changes by the SEC and pending court cases are challenging this protection.

By law, financial statements and disclosures must be factually accurate and complete. However, credit ratings have been exempt from this legal standard since 1981 by the SEC. Proponents of revoking this exception argue that the rating agencies should be held to the same standard and that liability will lead to more accurate ratings.

Opponents have four primary objections: First, the nature of the rating agency’s work is purely speculative and there will always be factors that are impossible to anticipate and will impact investment performance. Second, a rating is an opinion. A person has always been free to accept a rating or reject it. A prudent investor should use a rating as only one of several measures of risk.

Third, removing the protection would lead to extensive litigation that would place an undue burden on the ratings agencies. And finally, future ratings would be designed to avoid legal action and would likely be so indeterminate to pass legal review that they would be virtually useless.

S & P President’s Letter to the Editor

Interesting commentary from Deven Sharma, president of Standard and Poor’s.  Say what you will about the rating agencies and their role in contributing to the credit crisis (we would agree with much of the finger pointing, although certainly not all of the blame goes to them), but he makes some good points about the REASON ratings should be used.  More specifically, he makes the case that ratings should be used because the market finds value in them, not because government / regulatory language mandates it.  Given the events of the past two years, institutions should be decreasing, not increasing, their reliance on ratings.  And they should certainly have the choice to do so.  Anything else, such as government mandated reliance on third-party ratings, presents a prime opportunity for poor assessment of the true value of securities (“market value” becomes misaligned with true economic value) – overstating market value when a security gets a “clean” bill of health and understating it when a security is downgraded to “junk” status.  This again highlights the issue of why marking-to-market does not always represent true economic value for investors.  Third-party ratings are a pervasive reason this misalignment exists!  Check out some of the resources on this website to learn more about this disconnect and how third-party ratings contribute to it.

Why Rating Requirements Don’t Make Sense – StandardandPoors.com, January 19, 2010

Will New Ratings Reforms Be Effective?

The attached article talks about how the House recently made extensive progress towards eliminating all language from both laws and financial regulation rules that references rating agencies (NRSROs).  The “system” will no longer depend on such agencies.  These are the first steps of progress towards reform and are commendable.  However, the real wood that needs to be chopped is determining what the new system will look like when it no longer relies on the agencies.  This new system must consider many factors, but to ultimately be effective it must lead us to an economic value attached to the assets that are rated versus the simple “good” vs. “toxic” diagnosis that we currently have.

Here is the article:

One Cheer For Barney Frank – WSJ.com, December 23, 2009

Don’t Put All Your Ratings in One Basket

Regulatory over-reliance on ratings isn’t just a U.S. problem. As we have seen here in the U.S.,  using ratings as the ultimate measure of value is dangerous.

Ratings are too blunt a tool to measure economic value. It makes the ratings agencies the default arbiter of capital levels. The stakes are too high to use a single statistic measure.

ECB Must End Moody’s Veto on Greek Debt, Goldman Says – Bloomberg, December 18, 2009

A New Player in the Game

This is an interesting development in the evolution/restructuring of the credit rating infrastructure!  We have a NEW player now that will provide ratings – on a limited basis to start out – but they will NOT be charging the companies that they rate.  This removes the conflict of interest that has potentially been a source of so many problems and could lead the other, larger rating agencies to eventually follow the same model.

Morningstar Enters the Credit-Rating Game – Los Angeles Times, December 2, 2009

Breaking Away

The rating agencies are slowly showing more signs of independence, as well as analytical leadership.  Not just with regards to ratings securities, but in evaluating financial institutions and their macro risks.  They may not be making new friends in the process, but this tension is necessary and more of it will help keep things in check!

Credit-Ratings Firms Show Some Independence – WSJ.com, November 29, 2009

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