Institutional Investor's Alpha Magazine - May 2008 - (Page 41)

in rating corporate or government bonds, the other two main categories of debt. No single corporate or municipal debt issuer has enough market share to give it the heft to sway rating agencies. But most mortgage security products were issued by a handful of powerful investment banks, including Bank of America, Bear Stearns Group, Citigroup, Deutsche Bank, Merrill Lynch & Co. and Wachovia Bank. These ﬁrms could avail themselves of the agencies’ commercial services and consult with them about their methodologies and then adapt a product to achieve an investment-grade rating. These structured finance products represented a strong growth sector for the rating agencies. An analysis by Frank Partnoy, a University of San Diego corporate law professor, shows that Moody’s revenue more than doubled from 2000, when it went public, to 2004, in large part because the agency built up its structured products business. By September 2005, Partnoy notes, Moody’s, with 2,500 employees, had a market capitalization of $15 billion — the same as Bear Stearns, which had 11,000 employees. As pools of debt that included subprime mortgages but carried triple-A ratings were unmasked last year, calls for reform of the rating agencies multiplied. SEC chairman Cox offered some of the most critical testimony in an appearance before the Senate Banking Committee in February. “Regulators, including the commission, have increasingly used credit ratings as a proxy for objective standards for monitoring the risk of investments held by regulated entities,” he said. “The recent market disruptions highlight the limitations of this arrangement.” It’s unlikely that credit rating agencies will be the only ones to feel the hammer, says Richard Baker, the former Republican congressman from Louisiana who recently became chief executive of the Washington and New York–based Managed Funds Association, the main voice of the hedge fund industry. “There’s enough fault to go around at every level in the marketplace,” he adds. The mortgage originators, the investment banks that packaged the securities, the underwriters, the auditors and the investors all played a role in creating the crisis, Baker and other critics say. If ever there was a favorable time for reform, this is it, though defenders of the status quo say alternatives won’t be easy to ﬁ nd. “The great attraction of ratings is that they are simple,” notes Paul Coughlin, executive managing director for corporate and government ratings at S&P. “They digest a lot of complex information.” The allure of ratings, in other words, is that they are user-friendly, though Coughlin and others say they have far greater value than that. A rating agency’s analysis of a particular security, say those who provide them, can contain details that go beyond the risk of default, which is all a credit rating measures, though investors often pay little attention to the ﬁ ne print. “People still want to know, Is it single-A or double-B,” Coughlin says. One of the reforms the SEC is ﬂoating is the use of a different scale of symbols for different types of assets — corporate bonds, munis, collateral debt obligations and so on. Coughlin counters that almost all the feedback S&P has received suggests that investors prefer the single scale. The rating agencies for their part say they want to better educate investors. “Regulatory references to credit ratings don’t dictate investment strategy,” says Deborah Cunningham, chief investment ofﬁcer for money markets at Pittsburgh-based Federated Investors and cochair of a task force formed by the Securities Industry and Financial Markets Association, a New York trade group that represents the industry. Cunningham says the ratings are one investment factor among others: “It’s not the end of the process.” Columbia law professor Coffee cautions that, although reforms can bring new entrants to the ﬁeld, true competition will probably increase only slightly. “It’s hard to build the reputational capital,” he says. Skeptics need only consider the much-ballyhooed reforms imposed on the auditing industry after the Enron debacle, which set off the collapse of Arthur Andersen, one of the original big-eight accounting houses. Coffee notes that today four ﬁrms dominate the industry. MAY 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 41

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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