Friday, December 28, 2007

31 More Years?

"That spasm of reformist zeal resulted in the 2006 Credit Agency Reform Act--but the law clearly didn't go far enough. That's why Barron's now proposes some fresh and far-reaching measures to fix the rating system, starting with steps to greatly increase competition. ... Fatefully, the rating agencies decided to allow securitizers to slice these CDOs into a new capital structure that transmogrified 80% of the bonds into triple-A credits. ... But the rating agencies unquestionably were key enablers, by countenancing and legitimizing lethal capital structures. ... Most importantly, the SEC should promote more competition in the industry by speeding up its approval of new agencies, designating them 'nationally recognized statistical rating organization(s)'. ... The two top dogs preside over what the Justice Department terms a partner monopoly, as opposed to an oligopoly. ... This duopoly has proven inordinately profitable, which perhaps explains why Warren Buffet is Moody's top shareholder with a nearly 19% stake. ... True, the rating agencies have long escaped any legal liabaility for issuing errant ratings by asserting that their actions constitute free speech protected by the First Amendment. In essence, they portray their ratings as nothing more than editorial opinion. ... [John] Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong. ... Robert Reich writes on his blog that the system is tantamount to movie studios hiring critics to review their films and paying them only 'if the reviews are positive enough to get lots of people to see the movie.' ... [E]conomists Joseph Mason and Charles Calomiris reported recently, using Moody's own data, ... the five-year cumulative default rate between 1993 and 2005 was 24% for CDOs receiving Moody's lowest investment-grade rating of Baa. This compares with a five-year default rate of 2.2% on corporate bonds similarly rated from 1983 through 2005. ... Jeffrey Grundlach chief investment officer at TCW ... has an excellent suggestion for reforming the rating industry that he has made to several agency executives. 'Just Say No' when Wall Street asks them to rate securities that lack historically relevant data", Jonathan Laing at Barron's, 24 December.

If the SEC couldn't "fix" the auditing business in 31 years, why believe it can "fix" the rating agencies? The SEC should end the "NRSRO" designation. Anyone who wants to rate, rate. I have another idea: a rating agency accepting a fee from an issuer to rate a security assumes underwriter's liability. Further, the rating agency should be denied any "privity" defense with regard to holders of the security. Then it's: sue away and let the plaintiffs' bar discipline the agencies. I wonder how quickly the rating agencies will tell underwriters they can't afford to give unduly high ratings. I think the rating agencies would be afraid to rate securities "that lack historically relevant data" if they knew they would get sued over their ratings. See my 6 October post.

"So how can we increase transparency in a complex market where everyone involved profits by keeping the investor in the dark? One way would be 'a large lawsuit by a well-capitalized institution.' says Sylvain Raynes [SR], a principal at R&R Consulting, a structured valuation boutique in New York. Another way would be to utilize 'cybernetics, or the theory of feedback control, in both primary and secondary markets,' he says. (Here I thought the structures were incomprehensible. Now I find out that cybernetics is the key to enlightenment.) ... For our purposes here, the issue is the 'need to introduce secondary market monitoring in a meaningful way,' Raynes says. The primary market needs to develop 'valuation standards,' which 'could have avoided 90 percent of the problems,' he says. 'It is possible to know a priori that a deal does not work, that the amount of securities in the transaction is too high'," Caroline Baum at, 24 August.

I agree in part with SR, a "large lawsuit by a well-capitalized institution" would help. Still better might be an indictment of a rating agency and an underwriter under say, 18 USC 225, continuing financial crimes enterprise. Mike Garcia (MG), wake up! You might become New York State's next governor! Needing "secondary market monitoring" may be SR's way of saying our old friend is back, the classical agency problem. I can't see how developing "valuation standards ... could have avoided 90 percent of the problem". If SR could explain this to me I would appreciate it. Having been a CPA for many years, I've concluded in many instances, "standards" just protect the "professional" from malpractice lawsuits. Nor do I understand the phrase "the amount of securities in the transaction is too high". Too high for what?

18 USC 225 requires "a series of violations under section ... 1014 ... of this title". 18 USC 1014 states, "Whoever knowingly makes any false statement or report, or willfully overvalues any land, property or security, for the purpose of influencing in any way the action of ... any institution the accounts of which are insured by the Federal Deposit Insurance Corporation [FDIC], the Office of Thrift Supervision, ... the [FDIC], ... upon any application, advance, discount, purchase, purchase agreement, repurchse agreement, commitment, or loan, or any change or extension of the same, by renewal, deferment of action or otherwise, or the acceptance, release, or substitution of security therefor, shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both". Good authority indicates the rating agencies did this, i.e., Ann Rutledge told us; see my 27 December post. What makes 18 USC 1014 so juicy, is: willfull overvalution of almost anything to influence a financial institution is a felony. I wonder if Hank Paulson's Treasury Department attorneys knew this before he tried to float MLEC? Under any circumstances, MG, hop on this. Your governorship awaits.

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