Back in August- which now seems like an eternity ago- I wrote this post regarding two Wall Street Journal pieces of several weeks earlier. The articles focused on Terry McGraw, CEO of McGraw-Hill, and the company's evolving woes from its S&P ratings unit.
A quote from one of the WSJ articles which was pointedly repeated by some House member in a committee session last week involving rating agency executives was this pair of comments from an email, and its reply, between S&P staffers,
"We should not be rating it."
"We rate every deal......it could be structured by cows and we would rate it."
It seems that each major financial crisis has one or more signal phrases or quotes associated with it. Surely, this pair of email fragments is likely to be among those for this crisis.
Last night, I ran into an acquaintance who is a manager at one of the ratings agencies. In order to protect his identity, I won't divulge with which agency he is connected.
We had another in what has been a series of interesting discussions over the course of the summer and fall. This time, with last week's Congressional grilling of executives from his sector still fresh, our conversation seemed more emotional.
I suggested that Terry McGraw could well be on the way out in twelve months. On the basis of those August WSJ articles, alone, questions will be asked, and pressure will be applied to make S&P's parent pay a public price for its role in this financial mess.
My colleague noted that very few people realize just how powerful and unmovable, in the sector, S&P is. That they would have been insensitive to the evolving signs of stress in rated instruments, such as CDOs, because their market power is so great.
He told me the head of S&P's ratings unit during the past few years is already gone. Upon hearing this, I promptly suggested that this ex-S&P manager will, in all probability, wind up testifying before a Congressional committee next year, and will promptly roll and give up Terry McGraw as the instigator of the problem, due to pressure for growth and earnings.
My colleague agreed.
You'd have to be an idiot to not envision clever, eager young staffers for Democratic party Representatives and Senators compiling published material, e.g., those WSJ pieces, and assembling a fairly plausible theory that the heads of S&P, Moody's and Fitch pushed too hard for growth, abandoned prior ratings standards, and succumbed to pressure from their clients, the originating investment and commercial banks.
What was a bit surprising to me was my colleague's description of how investment bankers often successfully embarrass and humiliate agency analysts who cannot completely understand the complex instruments brought to them for ratings.
The result of this process has been, as is now clearly seen, the issuance of ratings by agencies on instruments which they either don't completely understand, or do understand, but yield to pressure from their banking clients, in exchange for fees.
My colleague and I then noted how this process insidiously aids the short-term focused bonus compensation at investment and commercial banks. It seems incomprehensible to many who do not work in financial services that what happened with the ratings of new CDO products can stem from something as simple as unbridled opportunism at issuing banks.
To understand this, consider the following example. If for a period of only three years, an investment bank's mortgage-backed securities business churns out record amounts of CDOs, bonuses can run into the low millions of dollars for quite a few mid-level managers. For most people, three years of $2-3MM bonuses, even after taxes, results in a sort of 'game over' financial position.
Regardless of the disposition of the enormous bonus pools paid out of the issuing profits on structured instruments rated by the agencies, the systemic damage was done.
Simply put, the issuing and trading profits on the most exotic instruments, which tend to be the most profitable, filtered their way through to the agencies which have been given special protections, in order to operate their oligopoly without anti-trust worries. Even in a sector with only three major players, someone will oblige an issuer flush with money, and provide the desired rating on an untested security.
As the largest of the ratings agencies, S&P is almost certainly going to become a target for Congressional fury. My colleague noted that more regulation is coming anyway. When I opined that perhaps protection from lawsuits would be removed, he quickly predicted that the business would vanish.
To which I replied that maybe that would not be a bad thing, or even a problem.
Do institutional investors really need ratings on large corporate credit? It's debatable. There's plenty of information available with which such sophisticated investors can assess risk.
The area where ratings really do provide value is in the municipal bond market. Of course, this is a sleepy, low-growth segment, which accounts for the push by MBIA, AMBAC and the ratings agencies into more exotic products in the first place, as I noted in this post.
Perhaps we'll have to see a radical transformation of the ratings business, now that it has publicly shown that it was for sale all along. Sort of like the tainted research of sell-side brokerages during the dot com equity bubble of a decade ago.
Not to mention, once it becomes clear to the public how the ratings business model works, the revulsion over how agencies are paid by the or issuer of the rated instruments.
Long ago, a friend who worked at S&P, but not in the ratings unit, told me a story about a multi-unit meeting he attended. At the meeting, one of the ratings staffers told what was obviously an old joke,
"What's the difference between piracy and the ratings business? Piracy is illegal."
Not a pretty picture for the average retail, or less-skilled institutional investor to envision.
It's a pretty sure bet that, one way or another, the ratings business, and some of its senior executives, are in for major changes in the years ahead.
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