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Ratings firm sees opportunity in chaos

Marketplace Staff Nov 29, 2007

Ratings firm sees opportunity in chaos

Marketplace Staff Nov 29, 2007


KAI RYSSDAL: There are villains aplenty in the subprime mortgage mess. You’ve got lenders that didn’t tell borrowers exactly what the terms of their loans were, home buyers who arguably should have known better, big Wall Street banks that got greedy at the prospect of easy money and the big ratings agencies Fitch, Moody’s and Standard and Poor’s.

They’ve all been criticized for glossing over the risks that were piling up in the credit markets. Earlier this week, former SEC chairman Arthur Levitt said they were plagued by conflicts of interest. But one ratings firm would welcome a shake-up.

Marketplace’s Amy Scott reports.

AMY SCOTT: In the courtyard of New York’s World Financial Center, Sean Egan nibbles on a treat from a pastry shop called Financier. He looks like a man on the brink of something. He’s applied to get his company, Egan-Jones, membership to an exclusive club, the one for ratings agencies approved by the Securities and Exchange Commission. Egan’s been trying to get in for ten years.

SEAN EGAN: We’ve spent time doing other things also.

There are just three main members of the club: Fitch, Moody’s and Standard and Poor’s. Like them, Egan-Jones checks the credit worthiness of a company’s bonds, and grades them for investors. But Egan-Jones charges investors for its ratings. The Big Three agencies are paid by the companies they rate. Egan says that’s a clear conflict of interest.

EGAN: We believe that the interest of investors and issuers are diametrically opposed. The issuers in general want the highest rating possible. Whereas the investors want an accurate rating.

Egan, and plenty of others, say that conflict has prevented Fitch, Moody’s and S&P from doing their jobs. They failed to catch the collapse of Enron, Worldcom, and more recently, mortgage-backed bonds, until it was too late. Now investors are crying out for an alternative. Sean Egan says business is already picking up.

EGAN: With Enron and Worldcom we were often times the lone voice raising these concerns. Now it seems that people throughout the whole financial sector are addressing these problems.

But when it comes to using ratings, many large investors’ hands are tied. Pension funds, banks and insurance companies can only buy debt that’s been rated by a Nationally Recognized Statistical Rating Organization. NRSRO for short. The Securities and Exchange Commission awards that seal of approval. Until just a few years ago, the only NRSROs were, you guessed it, Standard and Poor’s, Moody’s and Fitch. Joseph Mason teaches finance at Drexel University.

JOSEPH MASON: NRSRO status is the keys to the kingdom. Clearly Egan-Jones, and firms that don’t have NRSRO status, are locked out of this special world, and certainly cannot compete.

That’s starting to change. Last year Congress passed legislation to make it easier for firms to acquire the designation. An SEC spokesman says assuming all the paperwork is in order, Egan-Jones should finally get approved. But Josh Rosner, with research firm Graham Fischer, says Egan-Jones has its own conflicts. He says the firm may be free from issuer pressure, but Rosner says investors have their own reasons for persuading agencies to give good ratings. Downgrades can mean big losses for them, too.

JOSH ROSNER: If you’re one of the very largest holders of a security, the last thing you want is an analyst to actually have, you know, a negative view, or downgrade it. And so where you can put a little bit of pressure or help the analyst think about the value of rethinking their views, you might well do that.

Rosner sees other problems with the industry. The rating agencies are protected by free speech laws, so they’re not accountable for their opinions, and they’re under no obligation to question whatever a debt issuer says about its operations. Rosner says bringing in new blood, like Egan-Jones, is a good start, but he says regulators may have to intervene to restore faith in the system.

In New York, I’m Amy Scott for Marketplace.

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