Why Ratings Are Failing Us.(International Edition)(credit-rating agencies)(Essay)

Byline: Sean Egan; Egan is a founding partner of Egan-Jones Ratings Co. and Egan-Jones Proxy Services.

The credit-rating agencies won't call the next crisis, either, unless they stop getting paid by the companies they review.

Several months ago, I received a call from an investment officer of a French insurance firm who was spitting mad about his experience in the U.S. credit market. This guy had been told by his investment committee to purchase only high-quality bonds in the U.S. for his portfolio. So he invested in AAA-rated securities offered by major investment banks.

Unfortunately, he invested in the wrong AAAs--his were cut to D in only two days during the height of the credit crunch. He thought he was going to get back his investment and a little tip (that is, about 3 percent). Instead, he was told he would receive absolutely nothing. That is where the spitting-mad part comes in--"highway robbery," "fraud," "corrupt investment banks," "corrupt rating firms" and "corrupt regulators" were a few of the phrases he threw out in the course of the phone call. The sentiments of this gentleman are felt by many others, and I suspect we will not move beyond this credit crisis, the worst we've seen since the 1930s, until some structural problems within our credit-rating system are fixed.

The rating industry has been under fire--and rightly so--because so many securities that were rated at or near AAA later experienced massive losses, thereby causing widespread market disruptions. AIG, MBIA, Ambac and a slew of lesser-known AAAs have lost their coveted top-tier ratings. To better understand the problem, a little history is helpful. From the early 1900s until the mid-1970s, S&P and Moody's were paid by investors; if the raters assigned inaccurate ratings, they lost revenues. This time-tested system unfortunately morphed as bonds became a primary means for funding corporations, and various regulations and investment guidelines required ratings. Issuers of debt now provide 90 percent of the revenues for rating agencies. Naturally, they want the highest rating possible to reduce the cost of issuing debt. So, with the help of investment bankers, companies now go shopping to obtain the highest rating. ...