PrefBlog

The Globe and Mail astonished me today by publishing a reasonably balanced review of what ratings agencies do and why they do it. They also published a precis of Levitt’s op-ed in the Wall Street Journal.

There were three snippets in the G&M piece worthy of comment, the first from Brian Neysmith, former head of DBRS (and boy, I bet he’s happy he’s retired!):

Pretend you’re a park ranger, and a camper wants to cross a big lake. He tells you he’s got a canoe, a paddle and a lifejacket, and asks what his chances are of crossing safely. You ask him what his canoeing experience is, and conclude that his chances are decent.

But then the camper asks what he would have to do for you to conclude that his chances were excellent. And so you tell him that he needs to add a flotation device, heavy weather gear and an extra set of paddles, just in case one falls out. And you say that if he does all that, you’ll give him a 100 per cent chance of success.

This is, essentially, what the ratings agencies are doing when they are retained by issuers to consult on the structure of new securities – with the notable exception that they never, ever give anybody a 100% chance of success. All they will ever do is (as the reporter noted at the beginning of the paragraph, but forgot by the end) conclude that the chances are excellent.

The second snippet comes courtesy of an ABCP investor:

“When you’ve got cash sitting around, you phone your banker, or you phone your money desk, and you say ‘I’ve got cash, what can you show me?’ ” said Richard Gusella, chairman of Calgary-based Petrolifera Petroleum Ltd. “And they tell you, ‘I’ve got 30-day Apsley Trust R1-high rated paper, per DBRS, and other people are buying it.’ And they say this is better than bank paper, and so you buy it,” he said.

The company had invested about $37.7-million, or more than half its total cash, in asset-backed securities. Its cash management policy had been to invest in short-term securities with DBRS’s highest rating, R1-High. On Aug. 15, $31.4-million of the notes became due but were not repaid. Mr. Gusella says the company is not in financial difficulty now – but he wants his money.

More than half its total cash in this stuff? Mr. Gusella may well be a very skilled oil & gas operator – and the front-line decision to gamble may not have been his, but rather his treasury group’s – but if I were a shareholder in Petrolifera, I’d be asking some rather pointed questions about prudent cash management.

A relatively small company such as Petrolifera (shareholders’ equity of about $120-million, according to its most recent financials) should not be doing its own money market investing anyway. Pay the fee and concentrate on what you’re good at … most (if not all) of the banks have institutional money market funds; some investment counsellors do; it’s not really all that expensive.

I will point out as well that the quote makes him sound a little pompous (talking about ‘phoning his money desk’). Perhaps his remarks were misconstrued for brevity, but:

• all dealers will have a range of products
• if you don’t like one dealers offerings or prices, you call another
• it certainly sounds as if he bought whatever the friendly salesman told him to buy

I’ve emphasized in the past and will emphasize again: dealers are not your friends, no matter how many social functions they invite you to – or how much of a big-shot they make you feel like.

And one last snippet:

For instance, the Canada Marine Act sets minimum ratings on investments that port authorities can buy. And in a stroke of good luck or prescient planning, the act says authorities can only buy investments rated by two bond-rating companies – meaning that authorities couldn’t touch the asset-backed commercial paper that’s run into trouble because there was only one rating agency that graded it (DBRS).

No. Not “good luck”. Not “prescient planning”. Merely a reasonable, if rather mechanical, application of the Prudent Man Rule.

So, finally, we get to Arthur Levitt’s proposals (bolded, with my comments in italics).

• The SEC needs to set standards for agencies and punish transgressions. Too vague for much commentary! It makes my hackles rise a bit because it implies that the SEC should be regulating agencies, but I’m willing to wait for the specifies and will attempt to retain an open mind. Note that Mr. Levitt is a former head of the SEC … when you have a hammer, everything looks like a nail!
• Ratings agency employees shouldn’t be able to jump to investment banks they have helped to structure transactions.: This suggestion came up in the September 4 commentary. No! A thousand times, no! In the first place, there is no indication that this is, in fact, a problem. Secondly, it will enforce draconian restrictions on the career choices of analysts. And thirdly, it is inappropriate because agency analysts have no power to force anybody to do anything; they give advice. Full stop. This sort of restriction is appropriate for regulators but is not even applied to them. Regulation Services trumpetted the fact that their employees were jumping to the banks for fat paycheques as evidence of the impressive skill of their employees; let’s fix up this aspect of revolving-door regulation before going after mere advisors! I will, perhaps, give a certain amount of additional credence to a particular agency if they tell me that each analyst has “gardening leave” in their contracts; to give such a matter of judgement the full force of law would be abuse of regulatory authority. I would be much more impressed if the agencies reacted in the same way every single brokerage firm in the world reacts when an employee leaves: devote a lot of time to reviewing the employee’s work. In the brokerage’s case, this is in order to retain the clients for the firm; in an agency’s case, it should be to double-check the ratings assigned to the instruments reviewed by that employee. The ratings should never be the responsibility of a single employee in any event. I recently reported the DBRS downgrade of little rinky-dink ES.PR.B – that report has two names on it.
• Issuers should disclose any consulting services provided by ratings agencies. I’m of two minds about this one. Disclosure is a good thing, but too much disclosure leads to the voluminous and unread state of modern prospectuses. I’m more against it that for it, but don’t think it makes a lot of difference either way.
• Investors should be able to hold ratings agencies “liable for malfeasance that is more than mere negligence.” No! Investors do not pay ratings agencies any money; there is no fiduciary relationship between investors and agencies. I can buy something solely on the basis of its rating; I can buy something solely because I got an anonymous eMail telling me it was good. If investors want a fiduciary relationship, there are many shops out there (like CreditSights, discussed here recently) who are more than willing to fill that need.
• Investors must stop blindly relying on credit ratings, and instead do more research on structured products to determine their safety. Hey! Finally, something I agree with completely! I will also note that one or two errors won’t hurt you (much) as long as you’re well diversified.

Update, 2007-09-19: Douglas W. Elmendorf has published a commentary on current policy issues, in which he endorses

additional oversight by the SEC, a one-year waiting period for a ratings agency employee wanting to join a security issuer, and disclosure in debt-offering documents of any related advice provided by the rater to the issuer.

without further argument.

Update, 2007-09-24: The WSJ has reported on an interview of Greenspan by FAZ:

In an interview with Sunday’s Frankfurter Allgemeine Zeitung, one of Germany’s most prominent newspapers, former Federal Reserve Chairman Alan Greenspan sharply criticized ratings agencies for their role in the current credit crisis. “People believed they knew what they were doing,” Mr. Greenspan says in today’s FAZ. “And they don’t.”

Still, he doesn’t think it’s necessary to strengthen rating-agency regulation. Essentially, they’re “already regulated,” he says, because investors’ loss of trust means the agencies are likely to lose business. “There’s no point regulating this. The horse is out of the barn, as we like to say.” Greenspan also said he believes that the volume of structured-finance products will decrease. “What kept them in place is a belief on the part of those who invested in that, that they were properly priced. Now everyone knows that they weren’t. And they know that they can’t really be properly priced,” said Greenspan.

This entry was posted on Saturday, September 8th, 2007 at 4:05 pm and is filed under Regulation. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.