CRA's: A. Andersen all over again

Arther Andersen
Flawed through conflicts of interest

Arthur Andersen, founder of the now infamous accounting and consultancy firm, was an trustworthy man.  His company, founded in 1913,  developed a reputation for unwavering honesty. During these early years Andersen was asked by an executive of a local rail utility to fudge the accounts or risk losing a major client. “Not for all the money in America” was Andersen’s response. From this incident came the company’s motto: “Think straight, Talk straight.”

Andersen died in 1947, but the company boomed in the post-war years. By the 1980’s however, standards across the accounting industry fell. The reasoning behind this can be found by ‘following the money’. The ‘big five’ accounting firms, (PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, KPMG and Arther Anderson & Co.) developed consultancy practices throughout the 1970s and 80s. Arther Andersen's specialty lay in IT consultancy, and in a world where information technology began to change business practices beyond recognition, the revenues derived from this new venture swiftly became the primary source of income. As a result, the company’s auditors, the original breadwinners, where soon forced to push new and existing clients towards the more lucrative consultancy practice. Straight talking was soon forgotten.

Objective accounting standards and consultancy practices were simply not compatible.  Although Arthur Andersen & Co. is perhaps best know for its involvement with the fall of Enron, the company was also involved in various forms with the fraudulent accounting of Asia Pulp & Paper, the Baptist Foundation of Arizona, Sunbeam Products, Waste Management Inc, and the largest bankruptcy in history, that of WorldCom. Prior to the foundation and growth of the consultancy practice, fraudulent practices on such a large scale accounting was almost unheard of.

These scandals occurred because of the difficulties in running two separate entities under one umbrella. The desire to remain one of the 'Big Five' meant that high accountancy standards were sacrificed for potential consultancy revenue. Consultants quickly became the highest paid within the firm, much to the chagrin of the accountancy partners. Throughout the 1990s the accounting and consultancy departments of Andersen Worldwide battled for power, resulting in the break-up of the company, and the payment of USD1.2 billion to Arthur Anderson from Andersen Consulting (The rebel consulting arm broke off and became Accenture), and the resignation of CEO Jim Wadia. This split occurred in 2001, and although Enron came to the surface a year later, the corporate culture of appeasing clients meant that a major accounting scandal was a matter of inevitability.

The fate of Andersen Worldwide highlighted that despite the fact that accountants and consultants both need an extensive working knowledge of how a company conducts its business, the two practices do not necessarily go hand-in-hand. Conflicts of interest lead to internal failures. A similar problem has occurred within the credit rating agency industry. In this instance the conflict of interest lies in the rating of structured products.

According to Richard Portes, Professor of Economics at London Business School and Founder and President of the Centre for Economic Policy Research (CEPR): “Rating agencies exist to deal with the principle-agent problems and asymmetric information.” In other words, CRAs exist for the benefit of investors by supplying them with information they would be unable to receive, or is too time-consuming to obtain. Efforts to smooth out this information imbalance between investors and the products they are investing in can be achieved by auditors, journalists and investment analysts, all in very different ways.

Recently, rating agencies have earned considerably more than their other information ‘gatekeepers’. One of the major catalysts for this growth has been the demand for structured products. A rating agency may have a business method whereby it first advises a client on how to construct a security that would receive a certain rating, then in a highly profitable self-fulfilling prophecy, rate the newly minted product according to the CRAs earlier prediction, earning two fees in the process. In 2006, Moody’s received 44% of its revenues from advising and rating structured products.

Until the early 1970s, the investors paid for the ratings, rather than the issuers. At around the same time that accounting companies across the US were beginning to develop their consultancy practices, the new ‘National Recognized Statistical Ratings Organisation’ status forced many investors to give up securities that are below ‘investment grade’. Along with the more recent Basel II regulation, the need for rated securities has become inexorably intertwined with the majority of investment portfolios. But the cost passed from the investor to the issuer, leading to a less than objective treatment between CRAs and their new clients, and more importantly, considerably larger profits.

A recent CFA Institute member opinion poll found that 11% of the 1,956 respondents had witnessed a CRA change its rating in ‘response to pressure from an investor, issuer or underwriter’. More than half of this 11% believed that this was due to the fear that issuers would take their business elsewhere to a competing CRA. 17% believed the promise of future business from the issuer motivated a CRA to change rating.

Steps have already been taken to address such an immense systemic failure. While the SEC has suggested that CRAs could no longer structure the products they rate, the European Commissioner Charlie McCreevy has gone a few steps further by proposing regulation that prohibits the agencies from providing any advisor services.

Perhaps McCreevy’s most seismic proposal has been to determine how the rating agencies define themselves. “CRAs will no longer be able to use the defence that credit ratings are just opinions” McCreevy stated in a recent speech. Further they will not be able to hide behind the legal immunity of subjectivity if they get things wrong. This is of vital importance. CRAs have often escaped regulation as a result of poor ratings through claiming legal immunity on the grounds that they are financial journalists merely putting forward an opinion. As Portes succinctly points out: “Moody’s is much more profitable that the Financial Times or the Wall Street Journal”. If the CRAs are forced into taking an objective stance, then they will be forced to take responsibility for their actions if their fail to take sufficient measure to conduct credit ratings.

McCreevy also states that any rated agency or retail third parties that contribute to more than 5% to the CRAs annual revenue would have to be disclosed. While a good move in theory, in practice it doesn’t address the problems of repeat business affecting the CRAs relationship with certain clients. In 2005, near the middle of the structured product boom, Moody’s annual turnover reached USD1.731.6 million. Under McCreevy’s new rules, a rating agency could have a number of clients all reaching the 5% cap. Such a limit does not seem enough of a barrier to excessive profits that would stop CRAs continuing to give preferential treatment to certain clients.

More change is needed to dissociate the client from the rating agency. Other alternatives include a flat rate tax on all new credit products that would provide the rating agencies an impartial revenue. The nationalisation of the rating agencies has been put forward, however while the CRAs remain profitable, the political ramifications would be too great, especially in today’s climate. Others have asked for standardisation across the rating agencies. But standardising valuation models would be similar to having one giant independent CRA, eradicating competition.

This magazine believes that a totally new approach is needed to what is a systemic problem. Firstly, as McCreevy has highlighted, the rating and the consultancy practices need to be split apart. This could be done harmlessly enough given the proper handling by the regulators. This does not end the influence clients have on the dependant CRAs – objectivity is still an issue. John Dizard of the FT has advocated that we go back to the old ways where the investors pay for ratings. This doesn’t solve the possibility of client pressure. As the CFA Institute poll stated, the respondents witnessed a CRA change its rating in response to ‘pressure from an investor, issuer or underwriter’. It does not matter who the client is, the CRA industry has proven itself to be untrustworthy. Changing the client may not stop the CRAs bowing to investor pressure. The two alternatives are either to over-regulate the CRA industry, stifling growth and draining talent from an important and difficult job, or do make the clients anonymous. Keeping with the CRAs penchant for models, this latter method can be termed the Car Wash Model.


The Car Wash Model

Car Wash Model
There are no CRA industry standards effective enough to stop the lack of ‘straight thinking, straight talking’. The reduction of the CRA industry back to purpose of creating efficient ratings for the investor is the only feasible option. To eradicate client influence, all rating proposals must be passed to an independent regulator: ‘The Car Wash’. Within the car wash, the name of the issuer is eradicated, the only importance being the data relating to the product (for obvious reasons this model is only applicable to investment products, not the rating of actual companies). The CRAs then model and analyse the product, and return the results after a set time to the regulator. Time is important, as some of the structured products relating to the sub-prime mortgage market were rushed through the CRA in order to satisfy client demand, and where not analysed sufficiently. A billion dollar collateralised debt obligation cannot be rated in one night, as happened during 2006.

The regulator then passes the results back to the issuer, without informing the issuer who rated the product. The CRAs who most accurately rate products (judged over a set period of time) will in turn receive repeat business, not from any set client, but through an increased proportion of business the regulator receives. Any attempt to influence the regulator has far more dire consequences for all in question, and is far more damaging to reputations than the slipping a favoured analyst a designer watch.

It is likely that the rating agency can recognise products from certain issuers, but unless they rate the products objectively then there is no need to ‘fudge the books’. Poor ratings will result in fines. The only factor that will result in repeat business and more profitable CRAs is accurate ratings, not preferential client treatment.

CRAs must be broken up, and new regulation must be put in place to stop subjective ratings. The sooner this is done, the less likely one of them will go the way of Arthur Andersen & Co., where conflicts of interest led to accounting scandals, the break up of the company, and the eventual dissolution of the accounting practice. The CRAs must take full responsibility for their ratings, and they can only do so if they become rating agencies in practice, not just in name. It is time for a clean out.