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.

* * *
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.

* * *
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.

Please add your comments to the Opinion Journal forum.

Why Madoff Matters, the Value of Quality Regulation - 3 / 12 / 2009

Those of us that are forced by our selected news sources, be they financial or otherwise, to wait for the Madoff hearing results should be warmed by the fact that this matter will actually move us all closer to proper, more consistent regulation. That means the rules governing business in America will move one step closer to equality across the board. And I believe that the greatest value to regulation of business and financial practice is that it brings us closer to a truly free market environment.

Now champions of Adam Smith and his 'invisible hand", Ron Paul and Steve Forbes (both super shrewd guys) as modern day examples, would argue that government regulation and oversight is bad. What they really meant was that the current version of government regulation and oversight is bad.

Let me explain using Wall Street as an example. Most folks think that FINRA and the SEC watch the backs of independent investors. But the truth is the system is designed to protect the big guy first, and small investor second. I won't cover all elements of this statement today, but I will use the subject of standard regulatory review process as the theme.

Madoff Securities was permitted by the SEC and the NASD to fool the system for two reasons. The first is that he was a founder and former head of NASDAQ. Secondly, he had a seperate clearing / trading operation (seperate from Madoff Securities the culprit of the ponzi) and it was compliant with SEC disclosure regulations.

Now in my former capacity of Managing Director of investment banking at a 500 man Broad Street based investment bank, and in my consulting roles for other broker dealers, I have ample experience in the way the SEC and the NASD deal with financial institutions of different sizes and reputation. Here is their standard review process. To put it simply, each group, upon entering the premises for a special or annual review presents the firm's head compliance officer with a list of document requests that include investment banking transactions, trading and sales runs, and research examples. A random sampling is then selected from the information provided, and this sampling becomes the basis for the audit process.

Think about how easy, in the case of Madoff Securities, it would have been to pull one account's trading history and run an audit (trace the trades and monetary flow with the clearing institutions) and immediately see that there was a problem. When SEC and NASD professionals find a problem, they then look for a repetition of that same problem in the account being reviewed and then for the same problem in other accounts as well. This first step is done via the internet and can be effected in 20 minutes. 20 minutes. So the only explanation for the NASD and SEC both missing this simple and required process is that they didn't miss it at all. They made an internal decision to allow Madoff Securities to pay fines for 'inaccurate' or lax reporting standards and moved on. Madoff Securities likely had very few if any customer complaints, so why would these regulators want to openly audit Madoff Securities? Madoff securities would simply pay a fine, which is common practice, and move on.

I will tell you that smaller firms generally keep much better records and abide by rules more stringently because they do not have the spare cash available to pay the fines levied by the regulators as a penalty for findings of lax standards or violations. But it is also true that smaller firms, in my experience, are inevitably going to be fined for lax standards. The larger firms, former bulge bracket firms, are so well capitalized that they have their internal legal team monetarily settle out any violations as quickly as possible without admitting or denying the event ever took place.

Special treatment would be afforded the titans of industry, AIG, Citigroup, and Madoff as examples. They, on the outside, would have appeared to be disclosing accurately. These are highly talented and experienced institutions who are big parts of the financial industry. They know what regulators want and they deliver it, whether accurate or not.

And inevitably, this system which grants passes to industry giants while appearing to actively enforce regulations on small and mid sized financial institutions created an environment which allows for Madoffs, Citibanks, and AIGs to take advantage of institutional and individual market participants for decades without real penalty. The more these implosion events occur, the more the SEC and NASD will be required to treat all participants equally. And that consistency creates a foundation for a level playing field and maybe even a "free" market that Paul and Forbes would be pleased with.

Knowledge is value too - Build Value Every Day.

Brad van Siclen

AIG a Passthrough for Goldman, Merrill 3 / 9 / 2009

Well readers, there is really not much value to report concerning AIG. I am not a conspiracy theorist, but this one makes me wonder. Last week the US government put an additional $85 Billion into the ailing company. That brought their total pledged amount to $160 Billion. These amounts were originally to satisfy balance sheet liquidity requirements. Indeed in AIG's testimony to congress, "federal liquidity requirements" were used as the rationale for the loan. (and let's face it, this is no loan, in its best year (2006) the company reported 23.0 billion EBITDA, but 2007 and 2005 show a more likely 12.0 billion Edita. So in 13 years (at previous solvent balance sheet levels) the government will make its principal back. Anyone care to bet on that happening?

This scenario is akin to me asking my 12 year old to insure my losses with her liquid assets. Not one financial group that had its losses insured by AIG looked past the AAA rating. These are the experts who built their financial future on AIG's balance sheet and Moody's / S & P's ratings.

So where did this 160 billion loan "pledged" by the government go? The AIG CFO said, " the vast majority of tax payer funds have passed through AIG to other financial institutions." Those institutions include Bank America and Goldman Sachs. Bank America and Goldman Sachs. These are the same banks that lobbied the government back in the Fall to halt the short selling of financial stocks for 30 days. This after their traders (Merrill Lynch in the case of BofA) had earned huge profits shorting Bear Sterns and Lehman. Then the market's turned on them and they were able, under Paulson (the former Goldman chief, then Treasury Secretary), to stop the shorting of financial stocks (including their stock). Oh, and to take advantage of TARP funds and Government stimulus they switched their businesses licenses from Investment licences to Commercial banking Licences.

So the AIG bailout is really just a way to conduit MORE funds to BofA and Goldman. (yes that's an over simplification.) But these are firms that did NO homework on the liquidity of the AIG balance sheets when they paid AIG to insure certain of their key investment risks. These so called experts are permitted to take advantage of the system every where they turn to protect or off set their bad investment decisions. WE do not.

Is it a conspiracy? No. Unfortunately, our current government has neither the experience, nor the guts to pull off that kind of maneuver. Was there favoritism, most certainly. Is this a problem? In a free market, yes. It says to investors that there is no level playing field. That the rules can and will change to suit the big boys. So why then would any one invest in stocks? Scary thought.

So what value can we take from this? Your financial partners (AIG was to Goldman and BofA) must be highly scrutinized. If you need to insure your business risk, other than act of God insurance, the risk in the transaction is too much. And finally, do your own homework and use some common sense.

Build value every day.

Brad van Siclen

What is the AIG Value? 3 / 2 /2009

At this point AIG, and frankly many more insurance underwriters, finds itself in a horrific situation. Let me try to distill this into a simple discussion and answer why. Insurance companies make money by leveraging premium payments (they call it "investing") with the knowledge that, year to year, they will pay out an average of 100% of those premiums in claims. I'll repeat that, Insurance companies make money by leveraging premium payments (they call it "investing") with the knowledge that, year to year they will pay out an average of 100% of those premiums in claims. Some companies, the more conservative underwriters (Berkshire Hathaway for example) routinely pay out in the low 90% of premium receipts annually. The idea is to invest the premiums in very very low risk investments and pocket the difference (the underwriter's operating profits) and use these profits in enhance the underwriting capabilities next year, or to launch new lines of business.

But in the case of AIG and even Berkshire this year their investments with these premiums proved to be anything but low risk. It seems that cash and gold were the only "investments" that could be made this last year. So this requires highly liquid assets on the balance sheet to cover the shortfall. In the case of Berkshire, they had the highly liquid assets to cover the shortfall. In the case of AIG, they did not. So the government stepped in to cover their shortfall.
Why?

By this point each of us recognizes that AIG had extraordinary laxes in internal oversight. So extraordinary that many of their so called derivative strategies were in fact adding additional leverage to their balance sheets in a strategy which transferred risk to their shareholders and, as we will see to their insured, then paid big bonuses to executives and insurance salesmen.

BUT after bonuses are paid, AIG still had to pay claims. THE LARGEST OF WHICH WERE INVESTMENT AND BOND RELATED INSURANCE. Yes, AIG for a premium would insure returns on financial instruments. What do you think their exposure was in those insurance underwritings this year? And finally, when you add up all the banks, investment banks, pension plans, mutual funds, and other financial institutions that were covered in a downturn by AIG policies by AIG and its AAA rating (considered ridiculous my most industry experts) you face a systemic collapse in realized losses and redemptions in the investment world causing a ripple effect that creates immediate recession if not long term depression.

How was this mega house of cards created? Its simple, Fraudulent Accounting Practices. If value is misrepresented in order to justify a AAA rating, and that AAA rating forms the basis for the insured parties to further extend their balance sheets, the risk to the financial system grows geometrically, that's exponentially to some.

The Board members and executives of all of these companies have failed all of us, many have thrown their fiduciary responsibilities into the trash by ignoring questionable accounting practices to save their share price and save their bonuses and annual stipends.

This is criminal, not negligent. And worse, at AIG the executives in charge saw this coming 2 years ago and made little effort to stop it, in effect to insure the liquidity of their own enterprise.

So where is the AIG value - gone and hopefully gone forever. This was not value adding to our economy, this was gaming our economy for the benefit of their executives.

Build value every day - even in the face of shocking public company behavior.

Brad van Siclen