How America can revamp its rating agencies

Watch out! The Securities and Exchange Commission has the ratings agencies in its sites, and this time it means business.

Or so an observer would be led to believe, judging from the strong words issued by SEC Chair Mary Shapiro at an April 15 round table concerning possible reform of the $5 billion ratings agency business.

At the round table, Shapiro promised an intense review of the securities ratings world, which so famously dropped the ball during the housing boom and its recessionary aftermath.

It's a field ripe for questioning. At its core, ratings agencies remain compromised because their business model ensures they are paid by the firms they are rating. It's a model that has failed time and again, as larger, more powerful companies hold disproportionate sway with the agencies.

Or so says risk-management firm Kamakura Corp., which analyzed how Standard & Poor's rates firms, and found that among the 31 factors used by the S&P, firm size holds the most influence. In other words, the bigger firms get breaks that their smaller brethren don't.

This only makes sense when you look at the example of General Electric. On March 13, S&P cut GE's vaunted AAA debt rating to AA+, the first time GE didn't enjoy the highest possible rating in over 50 years. At the time, S&P voiced concerns about the impact the worldwide financial meltdown was having on GE Capital, its finance arm.

But such concerns were too little, too late as the damage had already been done to GE's shareholders. From the start of 2009 through March 13, GE's stock had already fallen 40.6 per cent. If you take those numbers back 12 months, GE's stock had already fallen 70.2 per cent by the time S&P got out its shears.

And GE is just the tip of the iceberg. Despite the toxic role mortgage-backed CDOs played in the subprime crisis, literally tens of thousands of such instruments once enjoyed the highest possible ratings from the agencies. As noted widely elsewhere, the fig leaf of a top rating allowed firms to get away with not doing their own research into these products, making the problem worse by several multiples. Of course, the SEC missed almost all of this, even as firms loaded up their ledgers with bigger and bigger bets.

But don't take our word for it, take Lloyd Blankfein's. Speaking at the Council of Institutional Investors' spring conference on April 7, the Goldman Sachs chief executive said that rather than do their own homework, "too many financial institutions and investors simply outsourced their risk management" to the agencies, which proved the riskiest ploy of all.

Alan "Ace" Greenberg, the august former head of Bear Stearns, sounded a similar call in an October 2008 interview conducted with Intelligent Investing. Greenberg quite candidly addressed why Bear got caught with so many bad mortgages at the same time, which ultimately lead to the firm's implosion. He laid the blame on a certain complaisance at the firm that stemmed from relying too much on ratings agencies: "You know when you say the word mortgage, and then you hear it's rated AAA by the various agencies, that makes you feel very secure. First, because a mortgage is a piece of property, and you have first claim on it. Second, because the ratings agencies rate it, so you get this false sense of security, which people will never rely on again, I can assure you."

But by then it was, again, too late.

Such examples are why the Forbes Investor Team says that at this stage in the game, ratings agencies should be at best ignored. But they do have at least a few suggestions for where we should go from here.

John Osbon, the head of Osbon Capital Management, says that an anonymous central fund should be set up that all firms pay into. The money to pay for ratings would spring from that, and the fund would be administered by the agencies, removing their central conflict of interest. "Seems simple doesn't it? Yes it is, but changing and adopting such a format is not easy."

Stephen Roseman, the head of hedge fund Thesis Capital, says that in the equity world, paid "research firms" are largely shunned, which makes it strange to him that a similar distaste doesn't exist in the debt markets. He recommends that firms do what his shop does, which is investigate firms and securities on their own. It's more work, but he says firms can't afford to not do it.

But what about individual investors, what should they do? Ken Shubin Stein, of hedge fund Spencer Capital Management, says that one metric investors could look at is earnings power over a full economic cycle, including the low points, divided by all needed cash payments.

If this sounds like a lot for individuals to do, it is. But this is why the SEC is talking about revising ratings agencies yet again. Let's hope this time that it actually leads someplace.

Ratings Firms Don't Rate

Forbes: There is now talk of revamping the ratings agencies. The SEC plans to hold a full-day conference on this topic soon. The reasons for this are manifold: The ratings agencies didn't really downgrade any subprime mortgages, didn't downgrade the investment banks as they collapsed and are deeply conflicted--as they are paid by the firms they are rating. In short, if analysts were the scapegoats for the tech bust, ratings agencies are filling much of the same role this time, and even share some of the same issues (i.e., being deeply conflicted and unable to be objective about firms paying them to rate them).

Clearly, there needs to be some changes here. What sort of changes need to happen to the ratings agencies in order to make them viable again? Why were they allowed to become so important, and yet so neutered when it came to real due diligence? How can they regain the public's trust? And what are you doing to examine companies now that the ratings agencies have been shown to have feet of clay?

John Osbon: There is one overwhelming fatal flaw in the ratings agency model: The issuers themselves pay for ratings. Imagine any other system that would adopt this model and the scorn and amazement it would create. What if models paid judges in the Miss America contest? How about NBA teams picking up the salaries of the referees? You get the point.

There is a solution, however, that would remove the conflict of interest the ratings agencies face--an anonymous central fund. Any issuer seeking a rating would pay a percentage of the dollar amount of the issue into a central fund, to be administered anonymously by Moody's, S&P or a consortium of rating agencies. Anonymity would insure that large issuers, like GM, would not influence or dominate the ratings process. The fund would allocate money to the rating agencies to conduct their reviews. Seems simple, doesn't it? Yes it is, but changing and adopting such a format is not easy.

Ken Shubin Stein: It has always been a bad idea to rely on a third party's analysis without doing one's own work. This is true for ratings agencies in the credit world and sell-side reports in the credit and equity worlds.

Forbes: Sure Ken, I understand that. But what should the revamped ratings agencies actually be charged with doing? How would you change their charters to make them actually useful again? And what are a few key factors you look for to gauge a company's health, since you can't simply trust a ratings agency?

Shubin Stein: I agree with John that a system without conflicts is a must. Incentives drive behavior, and this truth is behind much of what is wrong with Wall Street.

Earnings power over a full economic cycle, including the low point, divided by all needed cash payments is a reasonable way to think about it. A ratio over two at its weakest is moderately conservative.

Stephen Roseman: First and foremost, the issuers need to stop paying for their own ratings. In the equity world, there exists paid "research firms" that will write research on a company as a service paid for by the company. The irony is that most investors won't touch companies who adopt that practice. Why should the debt market be any different?! Either do the work yourself or use third-party independent research (to the extent that it exists).

Personally, I prefer to be hands-on and do the work in our shop and have my team doing the analysis.

I suspect you will see more investors employing that approach. They can't afford not to!

Forbes: Why does Wall Street keep falling into the same trap again and again: i.e., firms or individuals that rate other firms are paid by them? Ratings agencies, analysts, accountants--it's a scenario that's played out many times.

Also, what would you advise individual investors to do when it comes to what the ratings agencies say? Should they just disregard their picks? After all, there still is much news made when, say, GE is downgraded. Should investors just try to block out all this noise? Conversely, when does it make sense to pay attention to what the ratings agencies say?

Shubin Stein: As the system is currently configured, I would suggest ignoring the ratings agencies. Except Egan Jones.

Osbon: I think the rating agencies as currently structured have lost all credibility. Unless you are ready to do some serious credit analysis, or buy it from an independent source, I would stay away from the corporate bond area entirely. Or, you could index, as we do, since any one failure or major re-rating won't have a material impact. Moreover, with indexing you can own a diversified portfolio of bonds at institutional prices.