November 10, 2002
Jonathan G. Katz, Secretary
Re.: November 15, 2002 Hearing on Credit Rating Agencies (File Number 4-467)
The SEC describes itself as the "Investor's Advocate" with the following statement from its web site, "The primary mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors and maintain the integrity of the securities markets."
Since the SEC has elected to discharge this mission by awarding recognition to certain rating agencies (NRSRO's, in SEC parlance, which is currently limited to S&P, Moody's and Fitch), the issue of investor protection must therefore be addressed in terms of NRSRO performance. Such performance has fallen far short of an adequate level in protecting investors as witnessed by the following failures:
An additional indication of the failure of the current NRSRO's was a survey by H. Kent Baker and Sattar A. Mansi published in Table 9 of their June 18, 2001 article Assessing Credit Rating Agencies by Bond Issuers and Institutional Investors which indicated that only 29% of bond fund managers believe the NRSRO's updated their ratings in a timely manner. Since other firms succeeded in providing investors with warning, we believe the failures can be attributed to (i) a conflict in interest, and (ii) the lack of competition.
Regarding conflicts, we note a pattern similar to the Wall Street equity analysts since the current NRSRO's are supported mainly by the issuers (according to Moody's 10K, it obtains 87% of its compensation from issuers) and therefore have substantial conflicts of interests with investors. The adage "one cannot serve two masters" applies to the ratings field; a firm can either support issuers or investors. The conflict appears to be particularly acute for large important issues such as the California utilities, Enron, WorldCom, and currently, the auto firms. In these cases investors desperately need guidance from credit rating firms, but often do not get it because of pressure from issuers, investment banks, commercial banks and in some cases, security exchange officials (see the October 8, 2002 Report of the Staff to the Senate Committee on Governmental Affairs, Financial Oversight of Enron: the SEC and Private-Sector Watchdogs, page 113). Although argument can be made that any one issue represents a relatively small share of the rating firm's revenue base, the reality is that investors have not been protected. Revenues produced by Jack Grubman and Henry Blodget were likewise only a small portion of CitiGroup's and Merrill's revenues.
Regarding the lack of competition, the number of NRSRO's has declined from six three years ago to three currently. In the case of most US corporate ratings and an increasing number of structured finance transactions, S&P and Moody's are the only firms used. The industry could more accurately be described as a "partner monopoly", a term used by U.S. Department of Justice personnel. A partner monopoly differs from an oligopoly in the sense that the two firms share the market whereby the gain in revenues by one firm does not reduce the revenues of the second firm. Since two ratings are normally needed for the issuance of bonds, the gains of Moody's do not come at the expense of S&P and vice versa.
The problems associated with the lack of competition and conflicts of interest go beyond the Enron, Global Crossing and California utility failures. A letter (available upon request) from a senior executive at a brokerage firm whose clients were defrauded by Allied Signal which requested that the rating firms withdraw their rating of an issue of Grimes, an Allied subsidiary, so that investors holding the bonds would be forced to sell (because of the lack of a credit rating), thereby enabling Allied Signal to repurchase the bonds at a lower price. The response given by the rating firms for not rating the bonds was "an official of Allied ... told them they [Allied] would be very unhappy if that agency rated Grimes. That rating agency said candidly that Allied was a source of rating income and that they would not jeopardize the relationship". In another variation of the abuses of the NRSRO designation and anti-competitive practices, Moody's in the 1990's assigned an intentionally low rating to some municipal issues which refused to retain Moody's for its ratings services. In these and most other cases, Moody's successfully used the First Amendment protection, arguing that its ratings were merely its opinions and that it was exercising its freedom of speech. Individuals have the right to free speech, but when monopoly firm employs anti-competitive practices to extend its monopoly, the SEC needs to revoke its NRSRO designation. Because of the dominance of S&P and Moody's it is rare to find parties willing to file a public complaint against them.
Employees, pensioners, and investors were badly hurt by the failure of Enron, Global Crossing, the California utilities and other companies; more unnecessary pain can be expected unless and until changes are made in the seriously flawed system. We recommend the following changes:
Comments on Composition of Hearings
We do not believe that investors' interests are adequately represented in the composition of the Hearings on Credit Rating Agencies or that there will be any meaningful change in the non-independent partner monopoly that is the root cause of the failure to warn investors. The majority of the panel is comprised of the current NRSRO's, large security firms, large issuers, large investors (which are capable of doing their own research), associations representing large security firms (the SIA and Bond Market Association) and issuers (the Association for Finance Professionals) and large investors (the Investment Company Institute). One of the two academics included is conflicted (Schwarcz's research center is supported by S&P and the large security firms).
Conspicuously absent are independent academics who are considered experts in the field such as Larry White of NYU and Frank Partnoy of Washington University, consumer and investor advocates such as the Consumer Federation of America, the Department of Justice and groups that have been hurt by the WorldCom, Enron, Global Crossing and other failures.
Selected Quotes - Egan-Jones Ratings Co.
New York Times
July 7, 2002
"Egan-Jones makes a practice of alerting investors to corporate credit problems well before they are acknowledged by management... As early as November 2000, for example, Egan-Jones cut its ratings on WorldCom to the lowest investment-grade level, citing its deteriorating profit margins and credit quality."
Fortune's "Against the Grain"
January 21, 2002
"The best balance-sheet snoops are often way ahead of the pack in finding signs of trouble. Sometimes, however, the big credit-rating firms, Standard & Poor's and Moody's, which get paid by the companies they rate, are slow off the mark--slower, as a rule, than independent bond-rating services like Egan-Jones of Wynnewood, Pa...."We don't have the constraint of trying to keep a company happy," says Egan-Jones President Sean Egan, whose downgrade of Enron to junk beat the big guys by about a month."
Investment Dealers Digest (cover)
August 13, 2001
"It didn't take long for Sean Egan, managing director of Egan-Jones Ratings Co., a small ratings agency outside Philadelphia, to figure out last fall's California power crisis would eventually put the state's utilities in a bind. "We saw a train wreck ahead for these companies," recalls Egan, who says his analysts quickly fired off two reports to clients warning them of the troubles facing the state's two utilities-Pacific Gas & Electric Corp. and Edison International, the parent company of Southern California Edison. On Sept. 27, the firm lowered EIX's rating from A- to BBB-, and PG&E's rating from A to BBB+."
Grant's Interest Rate Observer
Annual Conference, October 2002
"The big two-and-a-half rating agencies have not exactly covered themselves in glory during the current credit debacles. Sean Egan, co-founder of Egan-Jones Ratings Co. (which saw many disasters coming before they landed in the newspapers), will discuss debacles and opportunities yet over the horizon."