Thursday, May 27, 2010

Ratings agency - Is there a conflict of interest?

If you were a rating agency and company XYZ was paying you a fee for your know that company XYZ's securities/bond offerings were of a poor quality, would you really write a report about them that would expose the securities/bonds as junk or report them as investment grade in order to raise additional fees?

Imagine it's mid 2007 today.

Pre-Global Financial Crisis (GFC). Before the worldwide market crashed. Before your retirement funds literally halved in market value. And if you live in the US, before your house valuation plummeted below your mortgage.

Would you behave differently knowing what you do now? We all would, if we could. As for Lehman Brothers, Bear Stearns and all those large investment banks, they would as well. After you read this, I hope you realise how important it is to perform your own research, investigation, analysis and due diligence on any fund, stock or security that you wish to invest in. Don't just rely on rating agencies guidance.

So what does 'credit rating' refer to? According to the definition provided by Wikipedia: "

A credit rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history.[1] A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by a credit bureau at the request of the lender (Black's Law Dictionary). Credit ratings are calculated from financial history and current assets and liabilities. Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.

A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rates, or the refusal of a loan by the creditor."

I've been tidying up my room, the massive piles of random articles, newspapaper clippings and magazines. Things that I found interesting at that time and wanted to re-read later. I found a few articles about the possible conflict of interest that undermine the rating agencies independence. These articles range between 2004 and 2007.

A Fortune magazine article (23 July 2007 edition) about Ohio attorney Marc Dann was quoted stating...
"The ratings agencies cashed a check every time one of these sub-prime pools was created and an offering was made...continued to rate these things AAA...among the people who aided and abetted this continuing fraud..."
Standard & Poor's, Moody's and Fitch Ratings. The three main credit rating agencies that came under Dann's attack. Pensions and Mutal funds in the U.S hold only investment grade bonds so they are unable to invest in these bonds unless the bonds are rated. Below is a guideline of S&P and Moody's ratings structure:

A different report by Alec Klein suggest that:
"...they are free to set their own rules and practices, which sometimes leads to abuse, according to many inside and outside the industry...they have strong armed clients by threatening to withdraw their ratings- a move that can raise a borrower's interest payments"
He cites some examples of the rating agencies doing a bit of bullying in order to maintain their fees: Hannover Re (a German insurer), Compuware (a Detroit computer software maker).

Back in 2007, Moody's code of conduct was:
"Moody's has no obligations to perform, and does not perform, due diligence."
The Fortune article went on to state that '...the other two agencies [S&P and Fitch Ratings] have similar provisions...'

What's the whole point of using the ratings if the rating agencies don't perform 'due diligence'?! Not only have they absolved themselves from being responsible but they are saying we will rate the bonds/security/etc however we don't have to perform thorough checks and have no obligation to do so.

Katie Benner and Adam Lashinsky wrote:
"Dann and a growing legion of critics contend that the agencies dropped the ball by issuing investment-grade ratings on securities backed by subprime mortgages they should have known were shaky...In addition to receiving fees from bond issuers that want ratings, S&P, Moody's and fitch do not vet data provided by these customers..."
If only people took more notice of Marc Dann's foresight, his allegations and his opinion. Perhaps pension funds wouldn't have lost so much if they did. Even in 2007, ripples of the sub-prime problem was reaching the pages in our own Australian newspapers, albeit a small section hidden in the midst of the stockmarket 'boom' articles.

If there's anything to be learnt from the past 3 years recently, it's to perform your own due diligence and don't just rely on 'expert' opinion. If it's your own funds at stake, take control and do your research prior to investing in anything.

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