Ratings Agencies and the Culture of Collusion - 3 / 17 / 2009

Readers, I have included an article at the Bottom of this piece from the Wall Street Journal On-Line Opinion Section on AIG. I will tell you that it in combination with may past writings it draws the key issues and themes on the subject of AIG's bailout and what Investors and American Business owners can learn from this debacle.

So my subject today concerns primarily the mysterious ratings agencies. Standard and Poor's (S&P), Moody's, and Fitch. I have a reasonable direct experience with these groups that dates back to the mid nineties when I socialized with a core group from the mortgaged backed unit of one of these agencies. I also studied under Ed Altman [http://pages.stern.nyu.edu/~ealtman/] who has consulted to and added dramatically to the financial models of one or more of the agencies. The good news is that these agencies risk models across all forms of securities and asset backed instruments tend heavily towards the conservative. More so than Valueline if you can believe that. The bad news is that they are paid by the groups that require their ratings in order to receive 3rd party financing. And the third parties I am speaking of are pension funds, endowments, and mutual funds.

These funds receive(d) investment opportunities from Wall Street on a sometimes daily basis, many carrying a rating from two of these agencies. Of course if an Agency decided to offer a rating on a product an investment bank wanted to sell that was below a rating institutional clients would buy, the deal would not only fail, but so would the relationship and future business between the ratings agencies and that particular wall street product group.

For example, if the Mortgage Backed Assets Investment Banking Group at Lehman Brothers wanted to sell USD 50,000,000 of packaged mortgages held by The Money Store, they would need to receive a A or AA rating on the offering in order to sell it to its University Endowment Funds or its Pension Fund Clients. These fund managers would then rely, on their experience with Lehman's Asset backed group and the rating placed on the securities in the Offering as delivered by 2 of the 3 major ratings agencies in making a decision to invest their client's capital in the offering.

During the 90's Moody's was considered the preferred agency with Fitch and S & P second. Why? well let's just say Moody's was a friendlier agency. But this made the folks that I knew at S & P feel like they were a lesser agency. They were making a bit less money due to their stricter ratings levels, even though they were doing a better ratings job...Great culture on Wall Street, huh?

I'll get into specifics on ratings processes at a later date, but i can tell you that the client was rarely viewed as the issuer (which it was) and normally viewed as the Investment bank (which was not the client). And guess who paid for this - - The Pension Funds and the University Endowments. Now they are not innocent in this either, but I think the conflicts of interest between the issuer, the agency, and the investment banks are the next item that Congress should look at. How could AIG retain a AAA rating for as long as it had? Why is it that ratings agencies downgrade issuers (corporations) after some series of events has compromised their balance sheets and not before the problem is recognized by the capital markets? What service are they really selling here?

Deregulation not only led to abuses in the banking and investment banking systems, it also created a culture on Wall Street and its third party advisers (ratings agencies, accounting firms, law firms) that so long as no one was getting really hurt, however we can cut corners on due diligence and get ourselves paid and bonused was ok. When I write of systemic abuses as they existed on Wall Street, the abuses are truly through out the systems, and this is why 50 percent or more of the world's value created by the Wall Street firms was recently wiped out. There were professionals who shared my perspective but unlike me ran large pools of capital that saw this culture coming to an end and ran for the hills. They began selling into speculative value peaks back in 2006..mainly because the volume, valuations, and volatility in the markets made little sense by historic standards.

So what's the conclusion here? AA and AAA ratings should always be viewed with suspicion as should the words "perfect", "the Best", "The Sage", "brilliant". These adjectives when used in the context of Wall Street firms and professionals have always given me pause. They should give you pause too.

Value is built incrementally and takes time in any industry. The quick buck artists and the guys making high high bonuses are leveraging other professionals value and likely taking very high risks at the expense of the business owners (the shareholders) to do so.

Build Value Every Day - And please read this excellent piece from the Wall Street Journal Opinion section attached below.

From the Wall Street Journal On-Line 3/17/2009

The Real AIG Outrage Article

President Obama joined yesterday in the clamor of outrage at AIG for paying some $165 million in contractually obligated employee bonuses. He and the rest of the political class thus neatly deflected attention from the larger outrage, which is the five-month Beltway cover-up over who benefited most from the AIG bailout.

Taxpayers have already put up $173 billion, or more than a thousand times the amount of those bonuses, to fund the government's AIG "rescue." This federal takeover, never approved by AIG shareholders, uses the firm as a conduit to bail out other institutions. After months of government stonewalling, on Sunday night AIG officially acknowledged where most of the taxpayer funds have been going.

Since September 16, AIG has sent $120 billion in cash, collateral and other payouts to banks, municipal governments and other derivative counterparties around the world. This includes at least $20 billion to European banks. The list also includes American charity cases like Goldman Sachs, which received at least $13 billion. This comes after months of claims by Goldman that all of its AIG bets were adequately hedged and that it needed no "bailout." Why take $13 billion then? This needless cover-up is one reason Americans are getting angrier as they wonder if Washington is lying to them about these bailouts.

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Given that the government has never defined "systemic risk," we're also starting to wonder exactly which system American taxpayers are paying to protect. It's not capitalism, in which risk-takers suffer the consequences of bad decisions. And in some cases it's not even American. The U.S. government is now in the business of distributing foreign aid to offshore financiers, laundered through a once-great American company.

The politicians also prefer to talk about AIG's latest bonus payments because they deflect attention from Washington's failure to supervise AIG. The Beltway crowd has been selling the story that AIG failed because it operated in a shadowy unregulated world and cleverly exploited gaps among Washington overseers. Said President Obama yesterday, "This is a corporation that finds itself in financial distress due to recklessness and greed." That's true, but Washington doesn't want you to know that various arms of government approved, enabled and encouraged AIG's disastrous bet on the U.S. housing market.

Scott Polakoff, acting director of the Office of Thrift Supervision, told the Senate Banking Committee this month that, contrary to media myth, AIG's infamous Financial Products unit did not slip through the regulatory cracks. Mr. Polakoff said that the whole of AIG, including this unit, was regulated by his agency and by a "college" of global bureaucrats.

But what about that supposedly rogue AIG operation in London? Wasn't that outside the reach of federal regulators? Mr. Polakoff called it "a false statement" to say that his agency couldn't regulate the London office.

And his agency wasn't the only federal regulator. AIG's Financial Products unit has been overseen for years by an SEC-approved monitor. And AIG didn't just make disastrous bets on housing using those infamous credit default swaps. AIG made the same stupid bets on housing using money in its securities lending program, which was heavily regulated at the state level. State, foreign and various U.S. federal regulators were all looking over AIG's shoulder and approving the bad housing bets. Americans always pay their mortgages, right? Mr. Polakoff said his agency "should have taken an entirely different approach" in regulating the contracts written by AIG's Financial Products unit.

That's for sure, especially after March of 2005. The housing trouble began -- as most of AIG's troubles did -- when the company's board buckled under pressure from then New York Attorney General Eliot Spitzer when it fired longtime CEO Hank Greenberg. Almost immediately, Fitch took away the company's triple-A credit rating, which allowed it to borrow at cheaper rates. AIG subsequently announced an earnings restatement. The restatement addressed alleged accounting sins that Mr. Spitzer trumpeted initially but later dropped from his civil complaint.

Other elements of the restatement were later reversed by AIG itself. But the damage had been done. The restatement triggered more credit ratings downgrades. Mr. Greenberg's successors seemed to understand that the game had changed, warning in a 2005 SEC filing that a lower credit rating meant the firm would likely have to post more collateral to trading counterparties. But rather than managing risks even more carefully, they went in the opposite direction. Tragically, they did what Mr. Greenberg's AIG never did -- bet big on housing.

Current AIG CEO Ed Liddy was picked by the government in 2008 and didn't create the mess, and he shouldn't be blamed for honoring the firm's lawful bonus contracts. However, it is on Mr. Liddy's watch that AIG has lately been conducting a campaign to stoke fears of "systemic risk." To mute Congressional objections to taxpayer cash infusions, AIG's lobbying materials suggest that taxpayers need to continue subsidizing the insurance giant to avoid economic ruin.

Among the more dubious claims is that AIG policyholders won't be able to purchase the coverage they need. The sweeteners AIG has been offering to retain customers tell a different story. Moreover, getting back to those infamous bonuses, AIG can argue that it needs to pay top dollar to survive in an ultra-competitive business, or it can argue that it offers services not otherwise available in the market, but not both.

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The Washington crowd wants to focus on bonuses because it aims public anger on private actors, not the political class. But our politicians and regulators should direct some of their anger back on themselves -- for kicking off AIG's demise by ousting Mr. Greenberg, for failing to supervise its bets, and then for blowing a mountain of taxpayer cash on their AIG nationalization.

Whether or not these funds ever come back to the Treasury, regulators should now focus on getting AIG back into private hands as soon as possible. And if Treasury and the Fed want to continue bailing out foreign banks, let them make that case, honestly and directly, to American taxpayers.

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