Market Regulators, Read This Now

*Ratings of Bear Stearns were listed as investment grade on the day the firm collapsed.

*Asset-backed securities loaded with subprime loans were uniformly given triple-A ratings up until late last summer, despite the fact that the housing market had already started turning south months before. Then last fall, the credit rating agencies knocked down within weeks to junk status almost half of the subprime mortgage bonds issued in 2006 and the first half of 2007.

*Embattled bond insurer MBIA still has its triple-A rating, despite its record losses and writedowns that has its thin wedge of a capital cushion teetering over the precipice.

*Bond insurer Ambac also somehow has held onto its triple-A rating by its fingernails, despite record losses. It continues to insure the debt of the state of California, the world's sixth largest economy. Both MBIA and Ambac have equity capital of $31bn supporting a $1.4t book of business. Only 16 publicly traded companies can boast having a triple-A rating, something IBM doesn't have.

*BusinessWeek says at the time of Enron's implosion that "What's gotten Washington's attention is their failure to uncover the extent of Enron's weakening financial condition and the pace at which they downgraded the energy trader in the months prior to its implosion....the agencies kept it at an investment-grade rating until just four days before it filed for bankruptcy on Dec. 2, 2001." Similarly, the New York Times said: "Credit-rating agencies, the independent securities analysts that pass judgment on a company's financial fitness, saw signs of Enron's deteriorating finances by last May. But the agencies - Moody's Investors Service, Standard & Poor's and Fitch Ratings - did little to warn investors until at least five months later, long after more problems had emerged and Enron's slide into bankruptcy had accelerated." The same has been said of the agencies in their slow reaction to WorldCom.

What gives?

The smooth functioning of global financial markets depends mightily upon solid assessments of investment risks. Credit rating agencies Standard & Poor's, Moody's Investors Service and Fitch get paid tens of millions of dollars each year to do just that, giving them an outsized role in maintaining investor confidence in markets around the globe.

But credit rating agencies are now under fire for what critics charge is their covert collusion in gold-plating junk subprime CDOs with Triple-A ratings, a misfire that has ignited a crisis which has rocked markets world-wide.

It wasn't supposed to be like this. In September 2006, President George W. Bush signed into law the Credit Rating Agency Reform Act, new legislation that was supposed to make several changes to foster competition in the credit rating industry and keep the agencies in line. Under the law, the SEC has the authority to inspect them and use enforcement tools if their practices prove abusive to investors.

Unfortunately, as the housing mess and credit crisis has proven, the law was not enough. Now Congress and regulators want a dramatic overhaul of the industry to stop what it says are the credit rating agencies' inherent conflicts of interest.

Worse, one sharp pencil on Wall Street who got an inside look behind the scenes at one credit rating agency says the problems still won't stop after the regulatory backlash.

He says what he heard left him chilled. And when I read what he had to say, I immediately became deeply concerned. So should market regulators and investors. 

For decades now, the credit rating agencies have been under fire due to a conflict of interest. They are paid by bond issuers to analyze securities, and then rate them, a conflict critics say caused them to turn a blind eye to things like dodgy subprime-backed bonds. Some agencies are alleged to have put risky CDOs together in many instances, then to have given them favorable ratings, in exchange for sizable fees. Market watchdogs had hoped this conflict would abate with the introduction of Egan Jones as a government sanctioned credit rating agency which doesn't get its fees from issuers.

Still, the conflict won't go away, as some credit rating agencies admit privately that if they depend on investors for compensation instead of issuers, they would go out of business.

"The rating agencies in some cases played both coach and referee at the same time" in assessing the risk of subprime and other types of investments underlying many securities, said Sen. Robert Menendez, D-N.J., in a recent keynote address at the Securities Industry and Financial Markets Association's conference. "Clearly, reforming the rating agencies has to be one of our top priorities" of the Senate banking committee, he added, noting "we need the regulators to be ahead of the curve, not in the cleanup brigade."

In their defense, the credit rating agencies say they are not auditors, that they rely on facts presented by issuers, that they don't have access to accurate and reliable information from issuers, that issuers deliberately withhold information from them they can't get in the public domain. They also say their ratings are protected by the First Amendment as they are in reality just opinions. And they still aver that they have solid risk controls.

But what really goes on behind the scenes at the credit rating agencies?

If S&P and Moody's are asked to rate a pool of mortgages, they don't actually look at the individual loans within the pool.

So, as one market analyst rightfully asked, if all the information about the assets underlying these bonds comes from the person selling them, and the credit rating agency never verifies any of it, investors might ask, what exactly does the rating agency provide?

But it's worse than that.

David Einhorn, who runs the hedge fund GreenLight Capital, says he met with a retired senior executive from one of the large credit rating agencies and asked him how his agency evaluated the credit worthiness of the investment banks. Einhorn says he talked to the executive after Merrill Lynch had reported large losses, and "asked him what the rating team found."

What he heard back was revealing--and chilling. Einhorn declined to name the executive by name, but what he had to say is worth reading.

Here's what Einhorn reported in a speech last month:

When Einhorn asked the credit rating agency official about the team that does the legwork analyzing the creditworthiness of investment firms, "he answered by asking me to refocus on what I meant by ‘team.'"

"He told me that the group covering the investment banks was only three or four people and they have to cover all of the banks. So they have no team to send to Merrill for a thorough portfolio review. He explained that the agency doesn't even try to look at the actual portfolio because it changes so frequently that there would be no way to keep up."

"I asked how the rating agencies monitored the balance sheets so that when an investment bank adds an asset, the agency assess a capital charge to ensure that the bank doesn't exceed the risk for the rating. He answered that they don't and added that the rating agencies don't even have these types of models for the investment banks."

"I asked what they do look at. He told me they look mostly at the public information, basic balance sheet ratios, pre-tax margin, and the volatility of pre-tax margin. They also speak with management and review management risk reports. Of course, they monitor value-at-risk."

"I was shocked by this and I think most market participants would be surprised as well. While the rating agencies don't actually say what work they do, I believe the market assumes that they take advantage of their exemption from regulation FD to examine a wide range of non-public material. A few months ago, I made a speech where I said that rating agencies should lose the exemption to regulation FD so that people would not over rely on their opinions."

"The market perceives the rating agencies to be doing much more than they actually do. The agencies themselves don't directly misinform the market, but they don't disabuse the market of misperceptions-often spread by the rated entities-that the agencies do more than they actually do."

"This creates a false sense of security and in times of stress this actually makes the problems worse. Had the credit rating agencies been doing a reasonable job of disciplining the investment banks--who unfortunately happen to bring the rating agencies lots of other business--then the banks may have been prevented from taking excess risk and the current crisis might have been averted."

"The rating agencies remind me of the Department of Motor Vehicles in that they are understaffed and don't pay enough to attract the best and the brightest. The DMV is scary...but scary does not begin to describe the feeling of learning that there are only three or four hard working people at a major rating agency judging the creditworthiness of all the investment banks and they don't even have their own model."