Comments on: U.S. SEC mulls stricter rules for credit agencies Mon, 31 Oct 2016 15:40:16 +0000 hourly 1 By: Henry Mermet Wed, 16 Sep 2009 12:22:50 +0000 Would you ever trust a law enforcement officer if time and time again he promised you that known crooks were law-abiding citizens?

The worldwide crisis has put the spotlight on false credit ratings. In the US, Chairman Dodd and his Senate Banking, Housing and Urban Affairs Committee must be commended for tackling this major issue; naturally this starts with fixing the ratings of structured products, since they are at the root of the crisis. However, it would be a grave mistake to stop there.

Flawed ratings of structured products are just one symptom of a much deeper evil, which is endemic to the issuer/pay model, to lack of accountability and to the schizophrenic arrangement whereby ratings are empowered by quasi-force of law through their effects upon financial investments via banking, insurance and pension fund rules throughout the world on the one hand, yet remain considered as mere “editorial opinions”, thus protected by the First amendment and therefore unaccountable to anyone on the other.

Beyond the rating of structured products, this deeply flawed model also affects sovereign ratings. An ill-perceived fact is that sovereign debt and sovereign ratings are just as strategically relevant to a state as the maintenance of an army. No wonder regulators and governments are not overly keen to enhance transparency here.

Yet flawed investment grade sovereign ratings result in prejudice to hundreds of thousands of holders of defaulted bonds issued by rogue yet solvent sovereign states who are thus given access to capital markets while simultaneously evading their repayment obligations to previous lenders.

In much the same way as, and for the very same reasons that, credit rating agencies (CRAs) awarded triple A ratings to what they knew – or should have known – were toxic structured products with a view to increasing their revenue, CRAs have quietly been assigning investment grade ratings to sovereign issuers whom they know to be in a state of unresolved default on debt obligations inherited from previous governments by virtue of the successor government doctrine of settled international law, despite the fact that according to CRA-published rating methodologies and definitions such investment grade ratings are only assigned to issuers who are willing to pay and settle their repayment obligations in full and on time.

They do this by disingenuously publishing footnote disclaimers concerning debt repudiations pronounced by revolutionary regimes such as those of Cuba, the People’s Republic of China, and Russia, knowing full well that the footnotes are not empowered by the quasi force of law attached to credit ratings themselves and will therefore not be binding on institutional investors who find themselves under the obligation to allocate specific amounts of capital to securities enjoying specific investment grade ratings.

This should not be mistaken for yesterday’s old-timer battle.

While the spotlight has mostly concentrated on the flawed ratings of structured products at the root of the recent crisis very little coverage has been allocated to the crucial matter of flawed sovereign ratings – although these now carry the germs of the possible next crisis since governments worldwide have de facto become the guarantors of last resort for banking and financial institutions and also private depositors, as a result of the wrongful actions of the CRAs leading to the subprime crisis in the first place.

And now that sovereign states are about to engage in a fierce competition to tap credit markets to fund their bulging deficits, more than ever before investors are going to need to tell the difference between the good, the bad and the ugly.

How intense is the pressure for CRAs to issue flawed sovereign ratings?

Had CRAs properly rated rogue solvent issuers such as the Russian Federation or the People’s Republic of China, who actively remain in a state of unresolved default, they would have forfeited each and every dollar of rating revenue from all and any issuers public or private of those two countries, by virtue of the sovereign ceiling custom whereby no issuer of a given country can enjoy a higher rating that that of the sovereign. We are talking of a potential revenue shortfall of hundreds of millions – if not billions – of dollars over the past 15 years.

Much more profitable for CRAs to assign an investment grade rating and quietly publish disclaimers on the side, which nobody reads, saying these defaults are irrelevant old hat nobody cares about, and that China and Russia have mended their ways.

Fact is: they have not. They remain fully responsible for the settlement of their predecessor governments’ payment obligations, which they can and do avoid before the courts, not on grounds of some form of limitation or cancellation but merely on grounds of sovereign immunity. And since on the other hand they are allowed to enjoy investment grade ratings assigned by the gatekeeper whom investors thought they could entrust with the mission of flagging the rogues, why should they ever bother to pay?

All this is happening under the complacent eyes of regulators who, just as they turned a blind eye to early Madoff warnings, have also turned a blind eye to complaints and documented evidence from holders of defaulted yet investment-grade rated sovereign debtors, see the very edifying complaint to the SEC (which did not act) at the following link: ter_to_SEC_Inspector_General

The problem is: how are investors to tell the difference between a bona fide sovereign who is demonstrably willing to pay debts in full and on time and a rogue state with a proven track record of taking evasive action, since CRAs rate them all investment grade regardless of who is willing to pay and who is not?

While some mostly cosmetic regulatory efforts are underway on both sides of the Atlantic to end the tortious actions of reckless CRAs and regulators the overhaul will remain a toothless tiger as long as CRAs remain immune to liability and protected by the First Amendment.

Columbia University Law School professor John C. Coffee is accurate when he testifies that the administration should adopt language from Sen. Jack Reed’s proposal that would make agencies liable for their ratings if they fail to either internally investigate the factual elements relied upon for rating a security or did not use other independent sources of verification.

However he is way short of the mark when he recommends that the liability provision could be limited to structured finance offerings which according to him “is where the real problem lies”.

Somebody needs to tell Prof. Coffee – and more importantly Chairman Dodd – about rogue sovereigns.

Any attempt at restoring confidence in credit ratings is doomed to fail if flawed ratings are only fixed piecemeal thus allowing unanswerable CRAs to persist in assigning knowingly false investment grade ratings to rogue sovereigns despite documented false public accounting and unwillingness to pay.

Sovereign ratings are not mere “editorial opinions” and everybody should realize just how much power they wield all the way up to governments, heads of state, and international treaties.

Ireland recently illustrated this when a few comments from a rating agency on the Irish sovereign rating prompted immediate and furious reactions from the heart of the Irish government. This is a fully contemporary and crucial issue.

The European Parliament recently voted an unsatisfactory Regulation for credit rating agencies. Further to the action of representatives of thousands of holders of defaulted sovereign bonds it has unenthusiastically asked the European Commission for a preliminary enquiry on the matter of misleading investment grade ratings assigned the many sovereigns who remain in a state of unresolved default: such as the Russian Federation of course, but also the People’s Republic of China, Poland, Hungary, Turkey, Greece, and others, see the press release at the following link:  ?url= es/up/203786733364141878/G20PREN.doc

Efforts such as these should be supported by anyone interested in restoring transparency, efficiency, confidence and finally sound performance to world financial markets and economies.

Thank you for your attention.

Henry Mermet