By Sean Egan, founding partner, Egan-Jones Ratings Co. and Egan-Jones Proxy Services - 04/22/09 07:39 PM EDT
As with most market failures, two elements were present: a change and a false assumption. The change was the shift in the manner in which mortgages were funded. For ages, when a person needed a mortgage, the local bank or S&L was the principal source.
The false assumption in the process was that the credit rating firm, unlike the mortgage broker or securitizer, could be relied upon for analyzing credit quality. Unfortunately, under the current industry structure where the issuer of the debt pays for the credit rating, such reliance proved to be severely misplaced.
Since most bond transactions require two ratings, when Fitch emerged as an acceptable alternative to S&P and Moody’s, ratings shopping became the name of the game. In an effort to obtain the lowest cost of funds, the firms issuing debt via their investment bankers solicited the rating firms to obtain the highest possible rating.
A conservative rating firm would turn out to be an underemployed rating firm. Add to this the fact that rating firms are protected from liability for malfeasance because ratings are deemed “speech” protected by the First Amendment, and all the ingredients for an economic disaster were present. Thus, competition, which is normally positive in a commercial context, had the opposite effect in the ratings industry due to the distortion of interests created by the issuer-pay system.
In the face of this anomaly some market observers have argued for a banning of rating firms, but such a ban would deprive the financial community of much of the legwork needed for assessing the multitude of securities in the market. (For an issue that is reviewed by several thousand buyers, it only makes sense to use some agents to reduce replication of workload.)
The best way out of this situation is to focus on the institutional investors who in many instances are fiduciaries that have an obligation to protect their beneficiaries.
As we have seen, it was a serious error to rely on conflicted ratings generated by firms that derive almost all of their compensation from the very companies whose debt they are rating.
The Reserve Fund would not have “broken the buck” had it used some reliable, independent ratings. Lastly, tying investment decisions solely to indexes containing conflicted ratings perpetuates a flawed investment process. A better approach is inserting some independent ratings and thereby forcing investment managers to take the few extra steps to make sure their fiduciaries are protected.
Until some meaningful steps are taken to restore checks and balances and thereby to reinstate trust in the system, and re-establish the flow of capital, the economic stimulus programs and various bailouts are likely to fall short and any recovery will be further delayed.
At a minimum, the SEC should require money mangers to disclose whether or not investment decisions are being made solely on the basis of issuer-paid ratings. Similarly, federal and state banking supervisors should require depository institutions to disclose whether external ratings are paid for by issuers.
Hastert joins Turkey’s genocide-denial effort
From Bryan Ardouny, executive director, Armenian Assembly of America
The April 10 Hill article, “Hastert contracted to lobby for Turkey,” is simply the latest example in a series of attempts by Turkey to curry favor on Capitol Hill. While there is no prohibition against representing a foreign government, we, as Americans, should all be concerned when a foreign government tries to impose its will on Congress.
Turkey, today as in the past, threatens to suspend relations with the U.S. if Congress or the president reaffirms a proud chapter in U.S. history in its response to the first genocide of the 20th century.
It was the courageous efforts of U.S. Ambassador to the Ottoman Empire Henry Morgenthau Sr. that first alerted the world to the “campaign of race extermination” against the Armenians at the hands of the Ottoman Empire.
Despite the clear and incontestable fact of the Armenian Genocide, Turkey continues its campaign of denial. As we mark Genocide Prevention Month throughout April and the anniversary of the Armenian Genocide on April 24, we should embrace, not deny, affirmation of the Armenian Genocide. In so doing, we will further the cause of genocide prevention.