Washington Post reporter Alec Klein was online Tuesday, Nov. 23, at 2 p.m. ET to talk about his three-part series on the enormous power wielded by Wall Street's three major credit-rating firms -- Moody's Investors Service, Standard & Poor's and Fitch Ratings.
In Part I of the series, titled "Unchecked Power," Klein looked at how the three firms have come to dominate an important sector of global finance without formal oversight. Part II focused on how the credit-rating firms influence the ability of nations to borrow capital, and Part III will look at the firms' business practices, which some corporations say has led to abuses.
A transcript of the discussion is below:
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Enjoying the series. After reading today's installment I wondered why more international organizations haven't objected to the power of the rating companies. Are they too frightened to challenge them?
Alec Klein: Good question. Many companies, both domestic and international say they are too afraid to speak out against the rating companies because the credit raters hold so much sway over their financial fortunes. But some sovereign nations--from Japan to Canada--have complained bitterly about what they perceive as unfair or inaccurate ratings. Various international organizations also have called for industry reform. But so far, there's been no action. The Securities and Exchange Commission, which oversees the industry, has studied the issue for more than a decade, and it says it continues to look into it.
Excellent work ! In the first two article you folks have explained the issue very well. But other than insistence of "some regulatory oversight" I did not see any concret suggestion for any solution. Problem stated without potential solution is just a "complaint". I suppose in the third article I would see some potential solutions. My suggestio is UN version of GAO can solve many problem uncluding this one.
Keep up the good work.
Alec Klein: Thanks. If regulatory solutions are to emerge, they will likely come from Congress or the SEC--or from regulators abroad. All have expressed serious misgivings about the credit rating business. Republicans and Democrats have been especially disturbed by what they see as the credit raters' failure to anticipate such meltdowns as Enron and WorldCom. At the SEC, officials are looking at such issues as conflicts of interest, access to confidential data and potential anticompetitive practices.
Are we really to believe that the directors of these rating companies, who sit on boards of companies that get rated, have no influence on ratings?
Alec Klein: Moody's says that its board members have no involvement in the ratings of companies on which its board members serve. But the situation raises at least the appearance of a conflict of interest, according to industry critics. Moody's, for its part, says that it has little choice because it wants the best people to serve on its board, and it believes that some of those people come from the companies it rates. It stands in contrast to much of the reform sweeping across corporate America, but so far, Moody's board hasn't been challenged by regulators.
Day One: Borrowers Find System Open to Conflicts, Manipulation
Day Two: Credit Raters Exert International Influence
Day Three (Wednesday): Flexing Business Muscle -- Lack of oversight has left the rating companies free to set their own rules and practices, which some corporations say has led to abuses. The credit raters have rated companies against their wishes and ratcheted up their fees without negotiation.
Mr. Klein: Why do you think the credit rating companies have operated under the radar for so long? I guess I used to think they were some kind of government-created agencies. I was surprised to discover they are profit making companies.
Alec Klein: Given the raters' power, it is indeed remarkable that the industry has operated under the radar. Some of it has to do with the fact that it's a complicated business that many don't understand. Also, it's clients are businesses, not individuals. In addition, until Enron and WorldCom and other corporate meltdowns, there was little political pressure for Congress to take action. Even when there has been a call to reform the industry, it hasn't lasted.
I found your articles on the rating agencies to be very well done. As a CIO for a life insurance company its nice to finally find someone who is willing to look at the reality of the rating process and not just the outcomes.
My question, comment, or gripe is as follows:
The rating agencies are susposed to do two primary things; (1) rate companies and entities over the business cycle and (2)understand the business models of the entities they rate. This means that a rating should be stable (predictable) and reasonable as compared to other entities with the same rating.
I see neither of this by either of the big two agencies. When you did your research did you discuss rating volitility? After 9/11 and post Enron, the rating agencies (an analyst in general)showed their ignorance in understanding business models and helped to create a situation where many good companies were endangered of not being able to roll debt over. They have done the same thing with "insurance" post Marsh Mclean - they didn't understand the business model and now the insurance industry has ratings risk. When 40% of M/M earnings are tied to commission rebates, I view this as material information and someting a rating agency/analyst would be aware of. Its not their view - today!
Bottom Line: The rating agencies look at default ratios. I think a more telling graph is the number of rating changes per year. Rating agencies do track up/downgrades, but they don't look at rating changes as a problem. As an investor, this is my biggest issue. Their ratings should be stable for the long-term, because the debt instruments they are rating are long-term contracts. Also, the rating agencies are using possitive and negative outlooks to bias the investment community on situations without ever making changes. In other words, if they don't change the rating and something goes wrong they "speak about the negative outlook" and if something doesn't go wrong or then they say they didn't change the ratings.
Alec Klein: Thanks. You're describing a situation that I've heard from others in the corporate world. There's a palpable sense among many I've interviwed that the rating companies have it both ways. They serve, on the one hand, an almost regulatory function by approving the bond sale of companies and countries alike, and yet the raters themselves are virtually unregulated. Few, however, have come forward to publicly complain to federal regulators.
Jeddah, Saudi Arabia:
1. Do credit rating companies use uniform standards that facilitate the comparisons of their rates?
2. Do governments (e.g. U.S. government) have any influence on the outcome of the rating?
Alec Klein: The rating companies say that they assess the finances of companies and countries through a combination of qualitative and quantitative factors. It's not simply a matter of punching in a series of numbers and coming out with a letter grade, they say. So, to that extent, their work differs. And yet, for the most part, their ratings tend to be similar. As for your second question, government officials throughout the world say they wish they had more of a say in the ratings process, and many say they are concerned that the rating companies in some cases have more influence on economic policy within their own borders.
Please forgive my lack of information...
Do these firms rate the credit-worthiness of the US Government? I know they rate states.
Have they downgraded any national, state, or local government's financial viability to a dangerous level yet?
Is that something that could happen sooner than later?
Alec Klein: Good questions, all. The first--yes, they do rate the U.S., along with scores of other sovereign nations. And yes, they have downgraded nations and municipalities to the extent that some have complained that the credit raters' have hindered their ability to raise money to deal with significant economic problems. Officials of the Dominican Republic, for one, say that its economic woes have been compounded by rating downgrades, and now it's in jeopardy of defaulting. Such complaints come from various corners of the globe.
What impact do the credit rating agencies have on people like me who have a significant amount of retirement savings in pensions, 401k and IRAs? Are there other ways in which "typical Americans" can be hurt by the oligopoly power held by Moody's and S&P?
Alec Klein: A good question. At a recent hearing, Congressman Kanjorski made the point that investors little understood the risks associated with such companies as Enron and WorldCom because they had been given strong ratings by the credit raters. The result, he pointed out, is that investors lost billions of dollars. Such losses would potentially impact retirement savings and other investment accounts of investors across the world.
No question the rating agencies are powerful and far from omniscent. To me, it seems your series blames them. But shouldn't investors bear the responsibility? Who says investors have to listen to the agencies?
Alec Klein: Investors do have responsibilty. But what sometimes confuses the issue is that the federal government has given a select number of rating companies a national designation, and investors have come to view that as the U.S. government's stamp of approval. Now, various mutual funds and other investment portfolios will only invest in bonds given good ratings by those credit raters given that national designation. When they miss big financial meltdowns at Parmalat, among others, it at least raises the question about that national designation. There are, for instance, no regulations or laws about how a rating agency can get the designation.
Seems like you fault the agencies for being too slow in some instances (Worldcom, Enron), and too quick and harsh in other instances (Canada, Dominican Republic). How do you propose this "can't-win" situation be remedied?
Alec Klein: That's what the rating companies say. They feel they get criticized for being too quick to react to problems, or too slow. They say they serve the public by giving investors a sense of the creditworthiness of a company or other entity. But their business model has raised questions. The big three rating companies get paid fees by the very entities they are rating, and some critics say that has proven to influence the process.
It seems that big companies are worried that rating firms -- even individuals at the firms -- hold their destinies in the palms of their hands, potentially subject to the slightest whims. But they don't complain because they're terrified of offending the raters. Why do they put up with it? These are people who are willing to send lobbyists into the halls of government to spit in some senator's eye.
Alec Klein: In interviews, some companies say they simply can't afford to alienate the credit raters when they depend on the ratings to access the debt markets and issue bonds to fund their growth. In some cases, companies and municipalities say they have been punished with what they call a hostile rating--a lower rating than they say they deserve--because they did not want to cooperate with the rating companies. They say they feel the impact in real terms: If the rating companies lower a company's ratings, it can raise its interest raise and cost it potentially millions in additional payments.
Since Moody's rates virtually every publicly listed corporation, who would you propose should serve on their Board of Directors who would not have a current or past relationship with a rated entity?
Alec Klein: Moody's makes a similar point. They say they want to have the most qualified people on its board, and they believe they tend to come from the corporate world it rates. And yet, some industry observers believe that there enough qualified candidates outside of the rater's realm of ratings. Board conflicts have become paramount in many circles, as the New York Stock Exchange can attest.
Silver Spring, MD:
You have described many troubling issues associated with the big three credit-rating agencies. Is the SEC--who I see didn't comment for your articles--really that interested or concerned about the performance of Standard & Poors, Moody's, and Fitch? I remember hearing about them studying this issue ten years ago without them acting. If the government is not interested, are there other organizations that are trying to identify the solutions?
Alec Klein: Good memory. Over the past decade, the SEC has periodically studied the rating industry, but taken no action. Usually, the regulators have stepped up their activity in the wake of a particular corporate meltdown. But when the issue dies down, so it appears does the scrutiny. The SEC, it's fair to point out, has been busy with a host of major corporate issues. But it says it is studying the issue now and hopes to make recommendations relatively soon. If the SEC doesn't act, some members of Congress have said they might take matters into their own hands to try to reform the industry. That includes Rep. Kanjorski of Pennsylvania and Rep. Baker of Louisiana.
Are there specific formulae involved in how credit ratings are assigned? How much rationale is made public? If an individual applies for a bank loan, for example, the bank is furnished with a detailed credit history report, not just a number. If the individual sees errors in the report, she can (arduously) work to get these corrected. Do firms and countries rated by Moody's, S&P, or Fitch's have similar access to their records? Is there any process for appeal?
Alec Klein: The rating companies say they make their methodologies publicly available through pamphlets and the Web, but many companies, nations and those on Wall Street say that the ratings process remains largely a mystery. The rating companies do not reveal who within their firms voted on borrower's rating. They don't reveal how the vote broke down. They do, however, publish their results, including the letter grade and the rationale for the rating. Still, the big rating companies say that their deliberations remain a private matter, and how they come up with a conclusion is a mixture of qualitative and quantitative factors.
If all the big companies pushed for reform, wouldn't they get it? Do they benefit in some way from an unregulated rating industry?
Alec Klein: There has been a quiet but growing call for regulatory action. The Association for Financial Professionals, which represents thousands of corporate financial officials in the United States, has done various surveys that show its members are unhappy with the accuracy and timeliness of their ratings. Counterparts in Great Britain and other parts of Europe have made similar complaints and called for similar action. Other complaints have emerged from Asia and Latin America. It still remains to be seen, however, how the SEC will respond to these concerns.
To what extent are the models open for these ratings? I'm sure the consumers of this information in the financial markets like the ratings but they're sort-of a synical lot (working in the equities research part of the industry myself). Does Fitch, Moody's or S&P license the underlying data elements and weighting or just the end-result ratings?
Alec Klein: The rating companies they their models are generally open, and in some cases, they do sell some proprietary financial models. But many in the corporate world say the basic ratings process remains too opaque; many say they would like to see how the raters handle conflict of interest issues and how they handle the use of confidential corporate data.
How do these companies stand up to standards they check? Do they have AAA credit ratings?
Alec Klein: Moody's does give an investment-grade rating to S&P's parent company, McGraw-Hill. The rating companies, however, say they have little interaction with each other otherwise.
Recently, a Northern Virginia political leader advised that the reason Virginia's AAA bond rating was in peril last year was because Gov. Warner forced the rating agency to do that - Warner wanted to use that as a reason for his propposed tax increases. I seriously doubt that the agencies could give a damn about political leaders. Do you think that partisan politics ever plays a role in ratings?
Alec Klein: Hard to speculate, but I've interviewed others who have explained how governments have at least sought to state their case to the credit raters. The raters say they do not allow such political pressure to influence their ratings.
Mr. Klein: I've missed your reporting. Glad to see you've been working on such an important issue. What made you decide to tackle this particular subject? Jennifer Sheffield
Alec Klein: Thanks; credit goes to my editor, Larry Roberts, who asked that I look into this little-known industry.
If these rater rate US, then how come US Congress and SEC regulators will not create "conflict of interest" situation ?
Alec Klein: It's a persistent question among many on Wall Street and throughout the world. The question, though, remains largely unanswered as regulators continue to study the issue.
Jeddah, Saudi Arabia:
You mentioned in the first article that a company may appeal its rating with the respective rating company. This may be reasonable for companies in the US since they have the chance to dispute the rating through the judicial system. However, for sovereign nations to appeal their rating with a company may not be appropriate and in most cases they would not have access to the same courts. What are your views on this issue? and is there any other proposed mechanism to handle disputes internationally?
Alec Klein: Many government ask the same question. In the United States, the credit raters have successfully defended their rating as opinions protected by the First Amendment. Overseas, many governments have complained that the credit raters are outside influences trying to dictate their own national policies. So far, there is no recourse. But in Europe, especially, regulators are beginning to band together to see if there's a way to confront the issue.
Thank you all for your questions. The third day of Alec's series will appear in Wednesday's paper and online at http://www.washingtonpost.com/wp-dyn/business.