Rating Agencies Became The Enemies During Financial Collapse.
Investors of all kinds, from small retail buyers to large banks, pension funds and their advisers rely on third party, arms length ”rating agencies” to do the dirty work in determining the real underlying worth of bonds and stocks–even those issued by sovereign governments.
The value of these services depends upon the agencies being unbiased. But the truth is that ratings agencies, such as Fitch, Standard & Poors and Moody’s, are paid by both the “buy” and the “sell” side of the securities business.
Buyers such as pension funds, corporations and commercial banks pay significant subscription fees to access security reports on almost all securities of any importance. But securities issuers also paid the agencies to rate their securities. And therein resides an obvious conflict of interest. How could an agency give a client poor ratings and stay in business? Working for the “sell” side, it was argued, would compromise agency ratings. The agencies countered that they separated employee pay from revenue sources and that their reputation for unbiased reports was far more important to their success than satisfying the desires of any individual client who happens to be paying the bills.
Prior to the most recent financial meltdown, cracks appeared in the agency assertion that objectivity could be maintained while taking income from the “sell” side of the business.
The massive collapse of Enron signaled something might be structurally wrong. That the comfortable days of being paid by sellers and buyers might be coming to an end.
This from a New York Times article Dec. 16, 2001 about rating agencies failure in warning investors about the Enron collapse.
“NOW that the Enron wreck has moved to Capitol Hill, perhaps investors will finally learn exactly who knew the gory details about the company’s hidden leverage and when they knew them. Since deception appears to have been the Enron way, Congressional subpoena power may be the only mechanism to get to the bottom of this disclosure disaster.
It didn’t have to be this way. Although most of the usual suspects — the brokerage firm research analysts, the accounting firm, the investment bankers — performed admirably as Enron enablers, there is a group that could have asked tough questions to help investors assess the company’s risks.
These professionals toil at the nation’s debt rating agencies, Moody’s Investors Service, Standard & Poor’s and Fitch being the largest. They are independent people who analyze companies’ financial positions and assign to corporate debt issues various ratings reflecting the securities’ risks.
The fact that Enron was able to hide significant leverage and other obligations from the public puts rating agencies at something of a crossroads. While they have traditionally taken a non confrontational tack with the companies they follow, shying away from the role of credit cops, aggressive work from them is now more crucial than ever for investors trying to assess the risks lurking in the capital markets.
There are several reasons for that. First, rating agencies’ work on the risks inherent among issuers has grown more important as the corporate bond market has exploded in size. According to Thomson Financial, some $700 billion has been raised through issuance of corporate debt this year, triple the amount five years ago. And that’s the debt investors know about. We now know, courtesy of Enron, that companies may carry additional obligations that are hidden from investors’ view, shunted off the balance sheet but for which shareholders of the company remain on the hook.”
Beezer. Re-read that last sentence. It was a clear signal from the Enron collapse that rating agencies were facing a much larger and possibly different set of challenges in rating company debt. Off balance sheet commitments that entangled shareholders in camouflaged, risky bets, played a central role at Enron. The same types of risky behaviour in the banking system this time around entangled not only shareholders but taxpayers too. In the trillions of dollars.
And once again the ratings agencies were asleep at the switch.
And like the Enron debacle, Congress is going to ask rating agency heads why they failed to warn investors about the risks being layered on by banks.
From the Mcclatchy news service April 20.