Exacerbating the Crisis The Power of Rating Agencies

The power of the three big US rating agencies, Moody's, Fitch and Standard & Poor's, remains unbroken. By awarding high ratings to junk securities, they fueled financial market excesses. Now they are taking countermeasures by brutally downgrading securities. In doing so, they are making the crisis even worse.

By Beat Balzli and

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

Fitch Moody's Standard & Poor's
Employees 3,000 3,900 8,500
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."

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

Ratings Explained

Standard & Poor's ratings levels explained in terms of likelihood of credit repayment
extremely strong AAA
very strong AA+/AA/AA-
still strong A+/A/A-
weakened capacity BBB+/BBB/BBB-
significant speculative characteristics BB+/BB/BB-
more vulnerable B+/B/B-
currently vulnerable CCC+/CCC/CCC-
in default D

Source: Standard & Poor's

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.


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