A Declaration of (Rating) Independence
by Martin D. Weiss, Ph.D.
February 25, 2011
The credit ratings issued by Standard & Poor’s, Moody’s, Fitch and A.M. Best are the brains and nervous system of the global financial markets. Those markets, in turn, are the heartbeat of the global economy. So when the integrity of the ratings is severely compromised, it places everyone in danger, including you.
Unfortunately, however, the public record of financial ratings reveals a series of deceptions, cover-ups and failures that have caused severe losses to millions of investors. Here are just three case studies:
1. Life and Health Insurance Company Failures (1989-92). In its landmark 1994 study of rating agencies, the Government Accountability Office (GAO) concluded that all four of the established agencies failed to warn of large insurance company failures until it was too late for most policyholders.
S&P did not issue a “vulnerable” rating for one of the biggest failed companies, Fidelity Banker’s Life, until six days before the failure; and for another, Monarch Life, until 351 days after the failure.
Moody’s did not warn about Mutual Benefit Life, the largest insurance company failure, until two days after its demise. A.M. Best, the leading insurance company rating agency, did not warn about Executive Life of New York until the day after it failed; Fidelity Bankers Life, until two days after it failed; Mutual Benefit Life, until three days after; and First Capital Life, until five days after. Moreover, for Monarch Life, Best never published its warning, instead taking its rating out of circulation four days after the company failed.
As a result, over six million U.S. policyholders were caught in insurance company failures for which they received little or no warning from established rating agencies.
2. Enron Failure (2001). The New York Times (“Credit Agencies Waited Months To Voice Doubt About Enron”) reported that S&P, Moody’s, and Fitch saw signs of Enron’s deteriorating finances in May 2001, but did little to warn investors until at least five months later.
However, these agencies later admitted that they were aware of a critical factor in the failure: that trusts related to Enron had made financial commitments which were tied to Enron’s own stock price.
3. Housing and Debt Crisis (2007-09). Congress and the Securities and Exchange Commission determined that the high grades issued by Fitch, S&P and Moody’s on thousands of mortgage-backed securities grossly inflated their credit quality, a case of negligence that played a pivotal role in the debt crisis.
The agencies also failed to warn the public about any of the major failures. On the day Bear Stearns failed, Moody’s rated the firm A2, the same rating it had published from June 1995 through June 2003; S&P gave the firm an A rating; and Fitch, an A+ rating, the same rating it maintained for 18 years.
Later, when Lehman Brothers failed, Moody’s still gave it a rating of A2; S&P gave it an A; and Fitch gave it an A+.
We witnessed a similar pattern with the failures of New Century Financial, which filed for Chapter 11 bankruptcy in 2007; Countrywide Financial, bought out by Bank of America in 2008; Washington Mutual, which filed for bankruptcy in September of that year; and Wachovia Bank, acquired by Wells Fargo by year-end 2008.
The cause of these disasters have not been resolved. It is now widely agreed that the root cause of these disasters lies in the egregious conflicts of interests that are part and parcel of the credit agency business model. Specifically, the ratings are paid for by the issuers, empowering them to achieve undue influence over the ratings process, and the agencies have earned additional consulting fees to help structure the very same securities they rate.
The agencies give issuers a preview of their ratings and often reveal their ratings formulas, helping the issuers manipulate their own data to game the system and more easily get higher grades.
This is why Senator Al Franken proposed doing away with the agencies’ three-way oligopoly of the credit ratings industry. (“U.S. amendment could curb rating agencies’ power.”) It is why Manhattan federal Judge Scheindlin denied the agencies’ motion to dismiss a class-action lawsuit against them claiming fraud, filed by King County, Washington and Iowa Student Loan Liquidity Corporation (“For Big Rating Agencies, the Blows Keep On Comin’.”) And it’s why a California state court decided to let the California Public Employees’ Retirement System go forward with its $1 billion lawsuit against the agencies claiming negligent misrepresentation (“Calpers Case Against Ratings Agencies Can Go Forward.”).
In nearly all the failures I’ve cited above, publicly available data made the risks evident well in advance and it was possible to warn ahead of time. (See Weiss Ratings study.) But in virtually every case, rather than protect investors from issuer defaults, the agencies’ priority seems to have been to shield issuers from public awareness.
Although the financial reform legislation signed into law by President Obama last year adds a layer of regulation over the credit rating agencies. It leaves their business model intact, including all its inherent conflicts of interest.
Today, we know all too well how catastrophic the consequences have been for investors, for the economy and, ultimately, even for the issuers themselves. Yet, little has been done to correct the causes — let alone protect you.
My recommendation: Rely only on ratings and research from independent firms that never accept compensation from the issuers and never give the issuers a sneak preview of the ratings.
Martin D. Weiss, Ph.D. is president of Weiss Ratings and author of the just-released book, The Ultimate Money Guide for Bubbles, Busts, Recession and Depression.