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BirdsEye View

Quote of the week: "You cannot strengthen the weak by weakening the strong." Abraham Lincoln.

And, in response to last BirdsEye View quote: "Since each debacle is different, the cautionary tale I'd tell the CEO you quote below is, be careful; the next time it will be a different weed that will take over the garden."

Story of the week (paraphrased from Lee Geiger's Daily Pundit): "A remote island has 269 inhabitants who fish for a living, but only 65-70 days a year due to the raging stormy weather. Life there is extremely simple. recently, an islander needed serious medical attention. As they were leaving the island the family became depressed and everyone began to cry. The mother told the captain: "It is a very real life back home. There's nothing artificial. Safe, simple, clean and kindly. It is hard, but it has its own rewards". Very zen, with a large kernel of truth in it.

One enlightening reaction to last week's BirdsEye View comes from Cathy Nash, CEO of Citizens Republic: "One of the things I see banker's struggle with is that they have more passion about their client than they do the bank. Those need to be in balance. So understanding the decision they make in regard to their client and its impact on the bank "making money" is critical. As the industry has gotten more and more sales focused, we've lost a bit on the side of what matters to the bank's bottom line.

The article below was written by my friend Jackie Reeves of Bell Rock Capital LLC and me. Jackie zeroed in on an important gap in the regulatory framework being contemplated in the legislature these days: the rating agencies. Let me know if you agree.

Our Forum season has started, and Arik and Dick are the only ones home. Liat is back in Chicago, Paul at Indiana University and Gil at UCLA. I'm excited about meeting so many friends during the forum season and look forward to learning a lot from everyone!

May you all be signed in the book of life (an old Jewish greeting before Yom Kippur),

The second thing I see is a value mismatch. Bankers know what they value, so assume it is what their clients value also. A perfect example is free checking. A branch banker thinks, "Well, it's free! Who wouldn't want free? I like free, so therefore all my clients and prospects will like free also." But not every client wants (values) free, they may value interest or avoiding ATM charges or other product features that don't come with free.

As we've talked to our line bankers about how the bank makes money, we try to use practical examples that help them with both balance and value."

Anat

Article synopsis : Don't forget the rating agencies in any regulatory reform.

THE RATING AGENCIES

As the markets continue to claw back from the daily lows, I wonder why one corner of the global financial crises still remains relatively intact: the credit rating agencies. This model has come under intense scrutiny but, unlike the accounting firms, which were forced to separate its conflicting businesses fairly quickly, the credit rating agencies remain unscathed.

It was October 2001 when Enron had acknowledged that the SEC was conducting an inquiry and the world changed. The accounting firms were forced, with the passage of Sarbanes-Oxley in 2002, to revisit the once sound idea of having them police the audit as well as provide consulting services. In hindsight the conflicts of interest appear obvious, but at an earlier point in time, the two lines business was viewed as complimentary. Today, an auditor can't offer consulting or tax services to a firm it audits.

The issue with the rating agencies is even more acute. A credit rating agency assigns credit ratings for issuers of certain types of debt obligations and the debt instruments. Investors depended upon these ratings to gauge debt obligations' risk for decades. On the SEC website there are seven Nationally Recognized Statistical Rating Organizations (NRSROs) including A.M. Best Company, DBRS Ltd., Fitch, Japan Credit Rating Agency, Moody's Rating and Investment Information, and Standard & Poor's. Investors make buy/sell decisions based, in part, on the ratings and their trends.

So, why are these firms still conducting business as usual and generating other income from the very companies which they rate? Has anything changed for these credit rating agencies since the start of this financial tsunami? S&P did begin rotating analysts to protect against conflicts last year. Moody's hired more compliance staff. And the SEC did step up its regulatory oversight earlier this year. But the basic business model remains intact.

Are these agencies seeking to restore confidence to the markets as it relates to their role, as many observers opined? I believe these agencies are first and foremost motivated by serving their shareholders, which imply a strong profit and growth motive. Rating see-saws continue, adding turmoil, not stability, to the markets. Some estimate the damage that can be traced back to improper ratings at more than $1.5B. For instance, the write-downs of securities rated by agencies took a hit of this magnitude since the beginning of 2007, according to the NYT, July 21, 2009. Last month a proposal was put forth to prevent agencies from consulting the firms they rate, providing a host of transparency-related mandates. FINALLY! Unfortunately, it's only a proposal, nearly a year and a half after the fall of Bear Stearns...

The proposed legislation currently on the table is designed to address three problems; lack of transparency, ratings shopping, and conflicts of interest.

The highest rating given by rating agencies is AAA, which is the rating given to the United States Government. It means that the probability of default is extremely remote. This designation was therefore highly valued, but, surprisingly, became more prevalent rather than scarce as borrowers and issuers were able to convince the rating agencies that innovation in the structured credit markets created nearly risk less credit investments.

Market practices such as "ratings shopping" before contracting for a rating, and consulting relationship agreements, may have contributed to conflicts of interest and upward pressure on ratings. Investors and even regulatory bodies began to rely entirely on the rating agencies' ability to assess risk consistently across instruments, and performed little or no due diligence to develop their own assessments. Further, investors ventured into products they understood less and less because they carried the "seal of approval" from the rating agencies. This reliance gave the ratings agencies extraordinary influence over the fixed income markets and their stability.

Debt issuers pay the various rating agencies for their rating service. Jerome S. Fons, Managing Director for credit policy until 2007, stated that "the securities issuers pay the agencies to issue ratings, and the agencies' interests can eclipse those of investors", according to the NYT, Oct 22, 2008. Further, "conflicts of interest were largely responsible for the disastrous performance of credit rating agencies in assessing the risks of mortgage-backed securities, two former high-ranking officials at Moody's Investors Service and Standard & Poor's said in the Congressional testimony."

Despite this condemnation, too much power remains in the hands of these rating agencies. Prudent issuers and investors should rewrite their investment policy statements and general practices, much like many had done with the issues at Fannie Mae and Freddie Mac earlier this decade. They should take control back firmly into their own hands. As they make changes and reduce their reliance on rating agencies as the sole source of credit worthiness assessment, more firms might enter the business segment to provide this service in a more market/investor driven approach. Using market forces to create the needed adjustments is a sounder way to affect changes in the current model, rather than constantly needing to police a flaw in the system. This will take time, but the sooner we start the sooner the system will become stronger.