Proposal to SEC to End Conflicts of Interest on Wall Street (Expanded)

On December 16, 2002, we submitted a proposal to the Securities and Exchange Commission (SEC) to end serious conflicts of interest at Nationally Recognized Statistical Ratings Organizations (NRSROs), particularly at the three leading rating agencies, Moody’s, Standard & Poor’s, and Fitch.

Since that time, these conflicts have, unfortunately, played a major role in entrapping the public into failed investments and failed companies, including asset-backed securities, as well as the stocks and bonds of some of the nation’s largest lenders.

Although the SEC has taken some positive steps toward investigating the business practices of NRSROs, the conflicts we cited in 2002 continue to prevail, as follows:

Conflict 1. All of the NRSROs are paid substantial fees for their ratings by the very companies that are the subject of the ratings.

Conflict 2. The rated companies are empowered to begin or end a rating contract.

Conflict 3. Rated companies can appeal and delay the publication of rating downgrades, but, naturally, never appeal upgrades. In many cases, they can also request that ratings not be published, and the rating agencies will oblige.

Conflict 4. Each of the NRSROs derives additional consulting revenues from the rated companies, compounding the conflicts of interest.

In recent years, the consulting business was especially problematic as the three leading rating agencies earned fees to help structure asset-backed securities. They helped create the securities; they rated the securities; and they rated the companies that issued the securities, collecting fees at each stage of the process.

Thus, not only did the consulting revenue boost the bottom line of the rating agencies, it also gave them stronger reasons to inflate their ratings, ignore warning signs, postpone downgrades, and avoid any steps that might undermine the structure they had helped to create. And these conflicts were an integral element of the housing and mortgage bubble of recent years, without which the recent bust could have been far less severe.

4 Case Studies

These conflicts of interest generally bias the rating process in favor of the companies and can often entrap investors in failing institutions will little or no advance warning. The following case studies are classic examples of this pattern:

Enron: According to the New York Times, “Executives at big securities firms that stood to profit from the [Dynergy rescue] deal pressed Moody’s to keep ratings at investment grade, even as Enron bonds fell to levels indicating that the debt was highly risky.” Responding to similar pressures, the other NRSROs also delayed downgrading the company’s bonds to speculative grade until after it was announced the company was filing for Chapter 11.

Thus, it was only after the Chapter 11 announcement that the rating agencies responded: Moody’s cut Enron’s rating by five notches, S&P slashed its Enron rating by six notches, and Fitch reduced its Enron’s rating by 10 notches.

Fannie Mae: Fannie Mae and its sister company, Freddie Mac, were placed under conservatorship of the U.S. government on Sunday, September 7, 2008, with the U.S. Treasury committing to bailout funds of $100 billion for each, the largest bailout for any company in history at that time. Common and preferred shareholders lost close to 100 percent of their money, while debt holders risked suffering severe losses.

But Wall Street rating agencies failed to downgrade the companies. S&P first gave the company a triple-A rating nearly seven years earlier and never changed it; Moody’s gave the company a triple-A rating more than 13 years earlier and never changed it; Fitch had continually maintained its triple-A for Fannie Mae for more than 17 years and never changed it.

However, outside, independent observers were as persistent in their warnings as these rating agencies were consistent in their praise. For example,

• In the fall of 1999, Treasury Secretary Lawrence Summers warned: “Debates about systemic risk should also now include government-sponsored enterprises, which are large and growing rapidly.”

• Six years before its failure, we wrote “Fannie Mae is already drowning in a sea of debt. It has $34 of debt for every $1 of shareholder equity. That’s big leverage and of the wrong kind. Plus, the company has only one one-hundredths of a penny in cash on hand for every $1 of current bills. Think Fannie Mae can’t go under? Think again.”

• In 2005, Business & Media Institute warned that “Fannie Mae was a looming taxpayer-backed disaster.”

Bear Stearns: On March 14, 2008, the Federal Reserve Bank of New York provided a 28-day $29 billion emergency loan and Bear Stearns signed a merger agreement with JPMorgan Chase in a stock swap worth $2 per share, or less than 10 percent of Bear Stearns’ most recent market value. The sale price represented a staggering decline from a peak of $172 per share as late as January 2007 and $93 per share just two months earlier.

However, on the day of the Bear Sterns failure, Moody’s maintained a rating for Bear Stearns of A2, the same rating it had published from June 1995 through June 2003; S&P gave the firm an A rating until the day of failure; and Fitch was even more favorable, assigning it an A+ throughout the 18-year period between February 2, 1990, and March 14, 2008.

The rating agencies claimed that the Bear Stearns failure caught them by surprise, and they couldn’t be blamed for not foreseeing what no one expected. But 102 days before the failure, based on publicly available data, we warned that Bear Stearns “had sunk its balance sheet even deeper into the hole, with $20.2 billion in dead assets, or 155 percent of its equity; and was threatened with insolvency.” Other independent analysts issued similar warnings.

Lehman Brothers: On September 15, 2008, Lehman Brothers filed for Chapter 11, a landmark event that marked a new, more advanced phase of the debt crisis, sending shock waves of panic in global markets. On the morning of its failure, however, Moody’s still gave it a rating of A2; S&P gave it an A; and Fitch gave it an A+. As soon as the news hit, the latter two rating agencies promptly downgraded the firm to D. But for investors trapped in Lehman Brothers shares and for lenders holding its debt, it was far too late to take protective action.

As with Bear Stearns, the rating agencies stated that they were caught flatfooted due to circumstances no one could have foreseen. But 182 days before its failure, we warned that Lehman was vulnerable to the same disaster that struck Bear Stearns. Plus, in the prior year, we wrote that Lehman was in a “similar predicament as Bear Stearns” because of an even larger, $34.7 billion pile-up of dead assets, or 160 percent of its equity. Again, we based our opinion on widely available data; and again, we were among several independent analysts that had reached a similar conclusion.

Other examples: We witnessed a similar pattern of rating agency bias in favor of New Century Financial, which filed for Chapter 11 bankruptcy in 2007; Countrywide Financial, which was bought out by Bank of America in 2008; Washington Mutual, which filed for bankruptcy in September of that year; and Wachovia Bank, which signed a deal to be acquired by Wells Fargo by year-end 2008.

To help avert more serious consequences in the years ahead, we reiterate the key proposals we made in 2002:

1. All NRSROs should be required to eliminate any conflicts of interest in their business model within a predetermined period of time.

2. Until that time, all NRSROs must fully disclose, at the point and time of distribution of the ratings:

1. the precise payments made by each rated company for acquiring its rating,

2. any other business relationships, such as consulting services, and

3. any procedure that grants the rated companies the right to delay or suppress publication of their ratings.

Wall Street’s ratings are the brains and nervous system of the global financial markets, and those markets, in turn, are the heartbeat of the global economy. When the integrity of the ratings is severely compromised, it places everyone in jeopardy.

Thus, we support SEC rulemaking efforts provided they eliminate the conflicts of interest we warned about in 2002. Separately, Congress should seriously consider terminating the NRSRO status of all rating agencies that continue to operate with such conflicts.

For more details regarding the severe consequences of NRSRO conflicts in recent years, see Chapter 4 of the author’s current book, The Ultimate Depression Survival Guide.