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Response to Barron's "Reforming The Rating Agencies"
Market Comment, 1/2/2008
RESPONSE TO BARRON’S
“REFORMING THE RATING AGENCIES”
Barron’s December 24th cover story (“Failing Grade”) was a
blistering attack on the reliability of Standard & Poor’s (S&P), Moody’s
and Fitch. The accompanying art work said it all—a red triple F over a
crossed-out black triple A. The article marshaled a lot of information
to make the case that the agencies had failed investors and must reform.
It was factually correct and, I fear, for the vast majority of readers,
viscerally satisfying.
Indeed, the agencies have had some embarrassing misses over the past
decade yet so has Wall Street. But as an alumnus of S&P and a credit
analyst for nearly 30 years I had a nagging sense of unease because the
burden of “perfection” is just as unrealistic for an individual analyst
as it is for a rating agency. Something, however, still failed to hit
the ball out of the park for me – and that something was a realistic
discussion of payment for analytical services in general. The harsh
truth is that investors simply want debt and equity analytical opinions
for free. Barron’s could have delved into the realities of securing
revenues from users of the credit ratings (not to mention the parallel
with equity analysis).
Based on my S&P experience and even today, operating as an independent
research analyst, there seems to be a perception that research should be
free. We should not forget Milton Friedman’s rule of social
economics that ”there’s no such thing as a free lunch.” Even if ratings
appear to the “public,” and to be “free” they are not. Public ratings
have a price regardless of who provides the research. Someone has to
pay for them –whether it is the issuers (as is mostly the case now)
and/or investors, perhaps both. The practice of having issuers pay for
ratings has a long-standing history in order that they can be freely
available to the public. (Obvious caveat: “you get what you pay for”).
The
Securities and Exchange Commission (SEC) empowered the agencies to issue
public “credit ratings.” The cry to “reform” the rating agencies
has been underway for as long as I can remember. I joined S&P in the
1970s in the wake of the Penn Central debacle. Wanting to avoid another
Penn Central, the rating agencies decided to significantly expand their
personnel ranks (i.e. credit rating analysts). Fixed costs increased as
did the need for revenues to cover staff expansion and delivery to the
public of credit ratings which were distributed through a publication
then entitled “The Fixed Income Investor.” This system had one
drawback; subscriber revenues to The Fixed Income Investor barely
covered the cost of publication (including analyst compensation) and
circulation. After Penn Central, the pressure was on the rating agencies
for in-depth analytical reviews of all public offerings exceeding $5
million.
It
should be noted that competition and alternative research opinions
pre-date the Penn Central failure, effectively weakening Barron’s case
that investors are entirely at the mercy of the Big-Three rating
agencies. Research opinions are offered by investment banking firms and
an array of research boutiques. Their analysts serve to cross-check
rating-agency activity. Barron’s proposed five-point prescription for
fixing credit rating process, along with our counterpoints follow:
1.
“The SEC must encourage
more competition by approving more rating agencies. Rating fees would
drop and diversity of opinion would lead to more accurate and timely
ratings.” Competition in the
rating business already exists; it’s merely a matter of where one looks
and how much they are willing to pay. As for competition driving down
fees I see a parallel here with the big corporate law firms. When is
the last time you heard a company say its lawyers reduced their rates?
Increasing the number of firms concurrently increases the industry-wide
fixed costs.
2.
“All rating agencies
should be required to disclose default rates on all classes of
securities they’ve rated. Agencies with bad results should have their
SEC approval yanked temporarily.”
A default rate is a statistic which can
be misleading.
Few issuers go into default without first experiencing a series of
downgrades and rarely does issuer do so without carrying a Triple-C
rating (Triple-C is defined as default is imminent). Barron argues that
the rating agencies should be better staffed with graduates from like of
Harvard and MIT. The Ivy leagued staffed Wall Street firms should not be
proud of their inability to anticipate the speed and magnitude of these
catapulting rating changes.
Insofar as temporarily “yanking the
SEC’s approval certification,” who would make such decisions? It
would likely create an even more confusing environment for investors,
especially if the particular rating service you depended upon was
unavailable; for many institutional investors and state funds, having
holding in their portfolio “unrated.”
3.
“Agencies must be
encouraged to make their money from investor subscriptions rather than
fees from issuers to ensure more impartial ratings.” Agencies
do not need to be prodded to charge subscription fees. It is investors
who need to be encouraged to pay fees. There is a parallel here with the
big accounting firms. How long would they be in business if they had to
rely on investors to pay them instead of the companies they audit?
4.
“Agencies no longer
should have exclusive access to non-public information, to even the
playing field.” As a practical
matter, I suspect the agencies have less access to non-public
information than one would imagine.
5.
“Agencies must say ‘no’
to Wall Street when asked to rate exotic types of debt instruments that
lack historically relevant performance data.” “Just
say no” sounds great, but it would probably have the effect of
constraining capital formation. In addition, exotic products are
generally constructed in tandem with the input and exchange of ideas
from investment banking firms – consequently, the inherent structural
risks are well understood by those who rate these instruments, those who
sell them and those who buy them. My experience indicates that an
increased level of caveat emptor is needed for buyers. Buyers would
rather have the seller summarize the risk/rewards of exotic and even
conventional issues.
There have been companies which have historically gone toe-to-toe with
S&P, Moody’s and Fitch. These ratings tended to take more liberties in
assessing risk, resulting in opinions which were oftentimes vastly
different than those produced by the nationally recognized rating
agencies. One of the thorniest debates in assigning rating has be how
earthquake risk should be integrated into the rating assessment for any
company with significant operations, for example, in California? If a
company’s total asset base was housed in California, would it be prudent
to issue an investment-grade rating (Triple-B) or higher, given the
earthquake threat? The same can be said for political risk: national and
international and international or State and Federal. The handling of
business risk ultimately boils down to an individual’s judgment.
Analytical judgments on a single element of risk could (and have) run
the gamut. They range from not rating any California company, since the
probability of an earthquake cannot be reliably established during the
lifespan of a particular bond issue, to others who feel there should be
an investment grade ceiling and others who would not consider the
possibility of an earthquake as a risk factor.
Herein lies another problem with any rating, whether from S&P, Moody’s,
Fitch or anyone else recognized by the SEC or not. Quality analysis is
time-consuming and expensive. Investors must understand that research
opinions issued by either stock or credit analysts carry a cost and the
cost and quality are usually correlated. Finally, there are other
points in the Barron’s article which come across as education snobbery
(read Ivy-sheepskin possessors vs. full-time analysts pursuing
after-work degrees). Among these is the author’s approvingly-quoted
remark by a hedge-fund manager that rating agency analysts (“including
many night-school MBAs”) are “simply overmatched by the Harvard
MBAs” from the investment institutions – who are not immune from failing
to get ahead of the rating curve, irrespective of the rating agencies.
Rating agency analysts probably have a greater breadth and depth of
experience than many of the by-the-textbook grads produced by Harvard,
MIT and the like. I defy Barron’s to question many of the most
successful people on Wall Street on their academic credentials. n
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