On Friday a headline in the Financial Times caught my eye: a day earlier Moody's had announced higher than expected revenue growth for the fourth quarter 2010 and an outlook for another strong year ahead.
This on the heels of Jesse Eisinger's January report that efforts, post-Lehman, to increase ratings agency oversight are quietly fizzling--or at least, stalling out. Portions of Dodd-Frank that were intended to impose greater legal accountability on agencies are currently on hold. Agencies responded to the potential change by refusing to allow their ratings to appear in offering memos, markets seized up, legislators backed down. And in December, in the wake of new fiscal belt tightening, the SEC's budget for the new Office of Credit Ratings was cut.
I don't tend to favor regulatory solutions to tough problems--and my faith in the SEC's ability to oversee ratings agencies effectively is moderate, at best. But--given the agencies' absolutely abysmal track records and the scope of their influence, when their profits head north while oversight heads south, it catches my attention.
The ratings agencies' issuer-driven business model has never made sense to me. I thought they'd been outed, post-Enron and Worldcom. But investors continued--despite past poor performance and the inherent conflicts of the model--to follow their lead off the cliff. In the wake of the most recent crisis, just as after the earlier one, there was tough talk about regulation and reform. As it stands, Moody's, S&P and Fitch have escaped from the mess they helped make remarkably unscathed, business model in tact.
Frankly, I liked David Einhorn's call last May to just get rid of them. But I don't think we can--at least, not just like that. Their products are deeply woven into the infrastructure of our system, institutionally and legislatively. For some investors they are a fundamental tool of the bond pricing process, they are relied upon by many mutual and pension funds for investment allocation decisions, and they are required for the calculation of reserve requirements for banks and other large financial institutions. Replaceable? Yes, perhaps, but not with the flick of a switch.
In December Guan Jianzhong, President of China's state-run Dagong Global Credit Rating Company published a white paper entitled The Strategic Choice of Chinese Credit Rating System. It is grounded in a stark assessment of the damage done to both the US and the international economic systems by US ratings agencies’ misses–holding them directly accountable for the resulting financial contagion in a way that few in the US have been willing to do.
It would be easy to dismiss Guan's analysis--he's biased toward a state-managed ratings solution, and he could be seen to be making a case for his own agency, which first issued sovereign ratings in July and subsequently downgraded its US rating in November. Yet we need only look--again--at the US agencies' records to know there's a lot of tough truth in his outsider perspective.
Absent a fundamental change in basic business model--or elimination, the answer to more reliable ratings agency product performance is probably some combination of systemic changes. Moody's has 38% operating margins, strong cash flows and almost $700 million in cash on its balance sheet. Taking it private might help--as a private firm it would be less subject to relentless earnings growth pressures, which might allow it to behave more responsibly and to positively influence the behavior of its peers.
Meredith Whitney and Jules Kroll both recently announced that they are creating new agencies. More competition can't hurt, although they are both using the traditional issuer-pays business model. There's a lone ranger firm--Egan Jones--making a go at the investor-driven business model--a tough nut to crack, but CEO Sean Egan is relentless and committed.
And in October the Financial Stability Board of the G20 issued a paper entitled Principles for Reducing Reliance on Credit Rating Agency Ratings. It's an exceedingly dry policy piece, but the encouragement to investors to assume responsibility for their own analysis mirrors that from noted bond investor Bill Gross--and the spirit of Einhorn's call for elimination of the agencies.
This, ultimately, is the best solution to moving away from dependence on the agencies' shoddy work product. When investors decide to make their commitments without agency input--and to communicate that they are not relying on agency analysis, the grip on the global economy of three irresponsible companies with combined revenues of less than $5 billion will be loosed.