Very few people have any reason to be pleased about the financial crisis, but Sean Egan is one of them. "Our business is going like mad," he says, clearly in an excellent mood. According to Egan, his company is doing "better than ever."
Egan runs Egan-Jones, a small rating agency outside Philadelphia. For years, he has been a professional rebel and vocal critic of the three biggest companies in his industry, Moody's, Standard & Poor's and Fitch, known colloquially as "The Big Three." Their business is rating financial products, and they have long dominated the market and continue to do so today. According to Egan, the Big Three make a lot of mistakes.
With their drastic lapses of judgment, the Big Three made investors worldwide feel secure -- up to the last minute before the crash. Their top ratings (Triple A) were still promising stability and profits, even as the foundations of companies were eroding around them. One of the most intriguing questions of the day is why they failed so spectacularly.
Lehman Brothers is a case in point. Only a day before the company filed for bankruptcy, the rating agencies were still awarding it their top ratings, namely A, A2 and A+. But Egan took a different view of Lehman, downgrading it to BBB+ half a year before the bankruptcy. Then he removed the plus and added a minus and, finally, one day before the bank, issued his death sentence: CCC. "Investors would have been better off listening to us," he says.
The same scenario applied to subprime mortgage-backed securities, as well as to virtually every company that has declared bankruptcy or experienced severe financial problems since the crisis began, companies like AIG, Bear Stearns and Merrill Lynch. While the Big Three awarded top ratings to all of these companies, Egan and his smaller competitors were far more cautious.
The question is: Why were they right? What are the lessons to be learned from the debacle? And who should be issuing ratings in the future, and according to what criteria?
These issues are at the center of bitter disputes in the financial industry. The major agencies' ratings determine the success or failure of bonds, structured financial products and entire companies. Even the creditworthiness of countries can suffer if the agencies' analysts form poor opinions of their finances. That happened to Spain in January, when its government bonds were downgraded, promptly causing a rise in Spanish interest rates.
Each of the agencies' plus or minus signs automatically triggers the flow of billions. When Standard & Poor's, Moody's or Fitch downgrade a company's securities, it routinely triggers a panic, forcing the affected company to obtain new capital as quickly as possible, while large funds caught in this predicament automatically sell their holdings. This was the way of the past, and, despite all criticism, it continues to be standard practice today.
The criticism has prompted investors to hold Moody's and the other two major rating agencies responsible for their losses. Regulatory agencies and governments in Europe and the United States plan to impose sharp restrictions on the major agencies, which, in turn, are fighting desperately to preserve their reputation.
The Big Three By 2008 Results
|Revenues||$882 mil||$1.755 bil||$2.645 bil|
|Profit||$246 mil||$748 mil||$1.055 bil|
|Market share in 2007||about 16%||about 39%||about 40%|
Source: DER SPIEGEL 19/2008
That reputation has suffered greatly, especially after the US Securities Exchange Commission (SEC) published a report on an investigation that contained damaging e-mails written by agency analysts. In the report, one analyst writes: "Even if cows were putting this deal together, we would still issue a rating." Another writes: "Let's hope we're all rich and retired when this house of cards collapses."
The core of the problem lies in the agencies' business model. They are paid to issue their ratings by precisely those companies whose securities they rate -- that is, the issuers of bonds and financial products. Those companies, in turn, are eager to achieve high ratings. The Big Three can be likened to aging hippies within a group of teachers, who receive joints from their students and, in the resulting constant state of euphoria, give them the highest grades in return.
"We all know that payment determines behavior," says Mary Schapiro, the new chairman of the SEC. She is currently President Barack Obama's most powerful weapon when it comes to financial policy. The rest of his economic team, including his treasury secretary and economic advisor, have been close to Wall Street for years and rarely criticize the financial sector. Schapiro, on the other hand, is not afraid of conflict. The agencies' poor performance, she says, has "shaken investor confidence to the core."
|Standard Poor's ratings levels explained in terms of likelihood of credit repayment|
|significant speculative characteristics||BB+/BB/BB-|
In mid-April, Schapiro held a round table discussion on the issue, inviting key representatives of the industry. One of them was Sean Egan, the Philadelphia rebel. Almost everyone present, except the Big Three, agreed with Egan's assessment that "things cannot continue without changes."
Practically everything is up for renegotiation right now. Everyone -- from the SEC and the US government in Washington to the European Union and German's financial regulatory agency -- is talking about the need for deep-seated reform in the industry. And there is widespread agreement that the scenarios in which investors suffered huge losses after blindly trusting the rating agencies should never be repeated.
The sharpest critics are calling for full disclosure, not unlike the health warnings on cigarette packages, using phrases like: "Warning: This rating was paid for by the issuer of this security." They would be even more pleased to see the establishment of a new business model for the Big Three, one in which investors instead of issuers would subscribe to their ratings, the argument being that investors have the greatest stake in hard-hitting analyses.
This was precisely the concept with which John Moody made a name for his company in 1909, when it issued ratings of highly volatile railroad bonds. During the 1929 market crash, none of the securities he had rated highly suffered sharp price declines -- evidence of his highly reliable ratings. Investors trusted Moody and were more than willing to pay for his objective analyses.
But in the 1970s, his successors and competitor Standard & Poor's changed their business model. From then on, they charged the issuers of securities for their analyses. At the same time, they developed a thriving consulting business. Sales and profits went through the roof. It was a foolproof business, despite the occasional errors of judgment. Ratings are always in demand, in good and bad times, and in many cases they are even required by regulators. The industry is not unaccustomed to seeing 30 percent returns.
In response to significant pressure, the Big Three are now working on their image. They want to change a little in order to save their highly profitable, oligopoly-like business model.
'Among the Main Culprits of the Crisis'
Torsten Hinrichs, the head of the German division of Standard & Poor's, is a cautious man who prefers to answer media questions in writing, and only through his PR department.
Hinrichs' response to a question about the "unsound assumptions" his company made about the US real estate market was succinct: "We regret it." The company, he wrote, has since appointed an ombudsman to address the needs of concerned investors. It is also taking 30 steps to strengthen the "independence and analytical quality" of its ratings. "However, it should not be overlooked," Hinrichs wrote, "that the performance of our credit ratings is outstanding."
This half-hearted apology is meant to placate the company's staunchest critics. They include Germany's chief bank overseer. Rating agencies are "among the main culprits of the crisis," says Jochen Sanio, the president of the German Federal Financial Supervisory Authority (BaFin). In Sanio's harsh assessment of the agencies' former practice of issuing high ratings for securities backed by subprime mortgages, they treated the rating of such structured products "as a profit machine, thereby squandering their credibility."
The pre-crisis profit figures reveal how lucrative the business with these "profit machines" was in the boom years. In 2006, Standard & Poor's raked in $1.2 billion (€900 million) in after-tax earnings worldwide, while Moody's collected profits of $1.3 billion (€985 million). The return on equity at the company's German subsidiary alone was an unbelievable 160 percent.
Those golden years are gone today. Earnings are shrinking, and the European Parliament is trying to impose sharper controls on the rating agencies.
Two Thursdays ago, the European politicians, acting in great haste, railroaded new regulations through the European Parliament. They include a new registration requirement for agencies. In addition, at least three members of an agency's supervisory board must be financially independent of the agency, and internal auditing departments must be installed to perform regular audits of the analysts' work.
The agencies' more scandalous practices are now banned. For years, they played an advisory role in the development of products for which they would later issue ratings. It would be roughly the equivalent of Germany's TÜV inspection agency approving cars it had built itself.
Standard & Poor's executive Hinrichs is satisfied with the changes. He believes that the new regulations will "strengthen confidence in credit ratings." But critics disagree.
While banks are under the permanent supervision of official agencies, the ratings experts often operate under the radar of government authorities. To prevent the agencies from failing once again, says Sanio, "they ought to be subjected to a comprehensive system of supervision that constantly monitors their methods and can sanction infractions." But this, he says, will "not be the case in the future, unfortunately, because even the planned EU regulations, with their registration requirement, do not offer significant improvement in this respect."
In their struggle to regain trust, the agencies are now bringing the mistakes of the past in line with reality. The banks can expect to see their toxic portfolios drastically downgraded. Moody's is leading the charge, as it revises its ratings of securities valued at $270 billion (€205 billion), and its competitors will likely follow suit. "As an act of self-catharsis, they are taking quick and brutal steps," says a member of the board of a German bank who is responsible for capital markets. The new rating models have been adjusted to reflect today's gloomy economic outlook, and the sins of the past, he says, will be corrected "with a tendency to overdo it."
In fact, credit ratings are already headed south at breathtaking speeds.
Securities with cryptic names like "Balta 2006-8 1A2," with which US subprime mortgages were artfully packaged and sold to investors in Europe, have lost their top ratings in no time. On March 10, 2008, Moody's was still giving Balta a Aaa rating. By late August, the same analysts had downgraded the same security by 14 grades, to B3, or "highly speculative." This year the security was downgraded to Ca, which is close to junk status.
The downgrades have triggered a massacre in the banks' balance sheets. Under the Basel II rules -- international banking regulations that have been adopted by most countries -- the greater the risk, the more equity a bank must have in its reserves as collateral for the security. For instance, if a security is valued at €1 million ($1.3 million) and Moody's gives it a Aaa rating, the bank must show only €5,600 ($7,390) in reserves for the security. But when the same security is downgraded to Ba1, the required capital reserve increases to €200,000. If the rating is lowered to B1, the bank must have €1 million in reserves to back the security.
This Basel II mechanism, which has exacerbated the crisis, also affects bank lending to companies. The lower a company's rating -- whether it was issued by one of the rating agencies or internally by the bank -- the higher the required capital reserve. This means that the bank no longer has access to the capital in this reserve, reducing its ability to lend money, for example, to the small and medium-sized businesses so urgently in need of capital.
Statistics compiled by Germany's central bank, the Bundesbank, already show evidence of a tightening in lending criteria. To address the problem, politicians like Alexander Dobrindt, the general secretary of the conservative Christian Social Union (CSU), want to see the Basel II regulations suspended.
But experts warn against such a move. "A softening of the Basel II equity capital standard as an anti-cyclical measure against the global recession could only take place as part of an international consensus," says BaFin President Sanio. According to Sanio, a national solo effort could be misinterpreted by international markets as "an admission of complete failure, and as an acknowledgement that important domestic banks are suffering from rampant equity capital deficiencies."
For this reason, Germany's coalition government is coming under growing pressure to ease the burden on private and state-owned banks by creating government-guaranteed depositories for toxic assets. The most recent spate of downgrades by Moody's is drastically driving up equity capital requirements. "This is yet another argument for a rapid introduction of protective solutions, such as Bad Banks or special purpose vehicles that would not be affected by rating agencies," says Wolf-Dieter Ihle, the head of Sachsen Asset Management.
Ihle should know. In his Leipzig office, he supervises, on behalf of the eastern German state of Saxony, one of the most prominent toxic waste dumps in German banking industry.
When the financial crisis erupted in the summer of 2007, the heads of the state-owned Sachsen Landesbank were the first to find themselves in a tight spot. After speculating with billions in Ireland, the provincial bank was brought to the brink of bankruptcy virtually overnight, and only an emergency sale to another state-owned bank, Landesbank Baden-Württemberg (LBBW), prevented the worst. During the course of this bailout, €17.3 billion ($22.8 billion) in toxic securities ended up on the books of a new company called Sealink, which was financed in part by a €8.64 billion ($11.4 billion) loan from LBBW and a €2.75 billion ($3.63 billion) government guarantee provided by the state of Saxony.
Now LBBW must come up with additional billions in assets to back its bailout loan. Although executives in Stuttgart are unwilling to cite exact figures, insiders say the bank could be required to add up to €6 billion ($7.9 billion) to its reserves.
In the coming weeks, other banks will also be hard-hit by the downgrading of their toxic assets. In addition to the usual suspects, like HSH Nordbank, WestLB and its toxic asset depository Phoenix, Commerzbank and Deutsche Bank also stand to be affected by downgraded ratings.
But will the Big Three continue to dominate the market in the future? Or will there be government rating agencies?
Agencies like Sean Egan's and other, smaller competitors have at least demonstrated that alternative business models exist. Following the example set by industry pioneer John Moody 100 years ago, these agencies are only paid by investors.
Rapid Ratings is taking perhaps the most radical approach. CEO James Gellert, a former executive in Deutsche Bank's investment banking division, does not employ a single analyst. Instead, he maintains a computer center in Bangalore, India, as well as offices in New York and Australia. The entire staff comprises only 22 employees, most of them computer and marketing experts.
"We do everything automatically," says Gellert, who opposes "subjective analyst research," preferring to rely on his computer programs. At least they are not in bed with Wall Street banks, he says, and they even predicted the problems at Bear Stearns, Citigroup and Merrill Lynch well in advance of the crisis.