Ratings Agencies Must Fight Together For Independence

The people who run Fitch and Moody’s, who still give the U.S. Treasury a triple-A rating and thus remain part of the Washington in-crowd, ought to recall Benjamin Franklin’s famous warning: “We must all hang together, or assuredly we shall all hang separately.”

The Justice Department has already sent out a hanging party for Standard & Poor’s, which downgraded the Treasury’s debt earlier this month. The New York Times reported that the department is investigating whether S&P rated various mortgage securities improperly in the years before the financial crisis. The Securities and Exchange Commission was already looking into S&P and Moody’s ratings of mortgage securities, and since the downgrade, the SEC also has reportedly demanded information about whether S&P employees leaked or traded on inside information about the Treasury ratings cut – even though S&P repeatedly said that it would reduce Treasury’s rating ratings unless federal deficits were cut faster and deeper than congressional negotiators ultimately agreed to do.

All this enforcement action, or threatened action, supposedly has nothing to do with the actual decision by S&P to cut Treasury’s rating. Administration officials and its SEC appointees would never dream of retaliating against a rating company for honestly expressing its constitutionally protected opinions. We know this because, though they will not say anything for attribution, they say so in all the stories reporting on their inquiries.

This claim is baloney. Merely by launching its investigations, the government has destroyed, for the time being, the agencies’ credibility when it comes to rating the government’s own debt. No matter what they do, or don’t do, the agencies are under obvious pressure to placate government officials who can put the companies out of business, and maybe put the agencies’ executives in jail.

In the face of this pressure, each of the agencies should withdraw its rating of U.S. government and agency debt. They should explain that government investigations render them unable to express an independent opinion. As a result, the government will end its tenure as a AAA-rated credit risk, not by having its ratings reduced (except for S&P), but by having them eliminated.

What I am suggesting is already standard procedure in many lines of work that require independence in appearance as well as in fact.

When a CPA is asked to audit a company, professional standards require his or her independence to remain uncompromised. If CPAs have an incentive to be anything less than honest, they are required to disclaim, or refuse to give their opinion.

Professional standards declare that an auditor’s independence is compromised if the auditor is involved in any litigation with the client over audit services, or in litigation on other matters that are material to the auditor’s financial position. Other standards hold that an auditor’s independence is impaired if the client owes substantial past-due fees.

It’s easy to see why. If I were auditing a company that owed me money, or if I were involved in litigation with the company, then I could have strong reasons to conceal the true state of the company’s finances.

Appraisers, arbitrators, journalists, baseball umpires, judges and many other professionals are expected to maintain financial independence from the parties with whom they deal. The rules vary in scope and strictness, but a common thread runs through all of them: You can’t opine credibly when your own fate may hang in the balance.

The government’s intrusion into the ratings business is both massive and massively misguided. On the plus side for the ratings agencies, all sorts of institutions, from trust companies to mutual funds, are required by the government to buy investments that have ratings from these companies. Since most securities issuers must pay to have their offerings rated, this provides a steady and reliable stream of business for the agencies. But it puts the agencies, which are private parties that can merely express their own opinions, in the position of being regulators and examiners for the institutions that buy rated investments. Financial institutions and their regulators should do their own homework, taking ratings into consideration when available, but not imposing a government mandate that any company’s ratings be bought.

On the minus side for the agencies, rating Treasury debt is like trying to dance with a two-ton gorilla. The Treasury does not pay to have its securities rated, yet its credit rating is the keystone of the world financial system – and the government has the power to put the U.S.-based agencies out of business and their key employees in prison. That’s unacceptable.

The threat of private litigation, not government prosecution, should keep ratings agencies honest. If parties that reasonably rely on ratings believe the agencies somehow cheated them, they should file civil suits and make their cases in court. Except in egregious cases, they will have little chance of winning, but the egregious cases will set boundaries. The remainder will underscore that ratings are just opinions; they are not predictions or guarantees.

Demonstrating how this process should work, Fitch settled a lawsuit this week that was brought by the California Public Employees Retirement System. The settlement does not involve Fitch paying any money to Calpers, which claimed Fitch issued wildly inaccurate ratings on structured investment vehicles that later collapsed. Fitch will turn over documents that Calpers hopes to use in similar litigation against Moody’s and S&P.

Fitch and Moody’s executives ought to take no comfort in the flak that S&P has received since it cut its Treasury rating. I am not suggesting they follow S&P with a downgrade; they should use their own judgment on that. But every agency ought to make clear that if the government does not take a laissez-faire approach to ratings, the agencies will get out of the business of rating the government.

About Larry M. Elkin 534 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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