Since the financial crisis started on August 9, 2007 with the credit agencies precipitously downgraded over one hundred issuers, I have felt that despite many flaws in the global financial system we could muddle through. As this apt British expression implies, you might get to the finish line somewhat disheveled and need to rely upon seat of the pants innovations to prevent falling into the abyss; however, you will at least accomplish your mission of survival. I still am optimistic about the financial outlook, but I have ramped up my demands for major overhauls in the system to prevent a future catastrophe.

Alas, added to the loss of their professional fiduciary standards of lawyers, investment bankers, commercial bankers, corporate executives, we are seeing the unraveling of another culprit—the credit agencies.

Let me elaborate, Connecticut’s attorney general issued on August 10, 2007 subpoenas to the three largest debt-rating firms as part of an antitrust investigation. I think that he will find fire among the smoke. The two largest agencies Moody’s Investors Services and Standard and Poor’s Rating Agency, control about 80% of the debt-rating market, which assesses the ability of corporations, banks, mortgage firms, governments, and other borrowers to pay back a loan. The smallest of the three agencies is Fitch. The attorney generals of New York and Ohio have begun inquiries independent of Connecticut.

The three agencies appear guilty in three key areas: 1) so-called unsolicited ratings, 2) so called notching and 3) the concept of exclusive contracts.

The attorney general’s complaint indicated that some raters conduct unsolicited ratings and then demand the issuer pay for it or face a possible poor rating.

Notching is when raters threaten to downgrade an issuer’s debt unless they get a contract to rate the issuer’s entire debt pool.

Exclusive contracts give issuers discounts for having all their debt rated by a single agency. This hinders competition by locking out other debt raters.

Why is the integrity of the rating agencies so integral to the function of the system?

In essence, just like the role of judges, you cannot have confidence in the legal system or the financial system unless you have impartial evaluators.

Unfortunately, several egregious outrages have unraveled my confidence in the credit raters. First of all, until this summer, the downgrading of hundreds of issuers at one time never occurred. That is, downgradings were selective. Thus, the massive downgrading of sub-prime borrowers implies benevolently that the credit raters either got an epiphany, were a sleep at the switch, or got an electric shock that woke up their somnolent grey cells to their impaired judgment. Secondly, the credit agencies downgraded some issuers in one fell swoop from AAA to junk bond status. This unheard-of fall from grace usually occurs with Olympic gold medalists found guilty of taking steroids; senators found misbehaving in bathrooms, or errant movie stars.

Stated differently, the financial system especially since trillions of dollars of obligations are sold throughout the globe depends explicitly upon the integrity of the rating agencies. If credit rating agencies are involved in extortion or can be bribed, the debt system loses its credibility.

Is there a solution?

First of all, the credit agencies must cease immediately blackmailing issuers by demanding they pay for unwanted ratings or requiring ratings on all of their issued securities.

Secondly, the rating agencies need to change their method of remuneration. That is, issuers, investment bankers, and institutions should pay an annual fee to the credit rating agencies that cover most of the costs of the credit agencies. In addition, credit agencies could charge additional fees for the right to call the agency to speak to the analysts covering a given credit.

Thirdly, no rating can be issued or altered without the concurrence of members of the institutional investment community’s involvement in the deliberation. While the credit agency could issue a rating, they must also include opinion of a panel of research analysts that work for the institutional investors. Having a consortium opine on credit ratings would prevent the monopolistic arrogance that pervades the current rating system. An analyst whose company owns a given security can partake in the assessment process, but cannot render a decision. In essence, this analyst must keep his personal views confidential to avoid a conflict of interest.

As I indicated in my first essay Fire Next Time, August 15, 2007, the financial markets were ripe for a major meltdown. However, I felt that the world’s central bankers could overcome the problems this time. Nevertheless, fundamental reform was necessary to prevent long term damage to the world’s economies. Since the great depression led to the accession of Adolph Hitler, who until 1929 had a meager following in Germany, one cannot dismiss to interconnection between economic travails and the ascendancy of political demagogues.

In Fire Next Time, I raised my concerns about over leverage in the financial system, the widespread availability of credit to high credit risks such as sub prime borrowers or leveraged buyout private equity firms, the arcane proliferation of sophisticated financial instruments, and the interconnection globally of financial players.

Over the next two months, we have read about financially engineered products turning into Dr. Hyde inventions in the mortgage and credit world, the failure of senior financial executives of investment banks, commercial banks, and institutional clients to hedge appropriately their outsized exposure to toxic financial instruments, the immoral actions throughout financial organizations to misrepresent the value of their inventory to clients and their own institutions, and the cancerous impairment of judicial judgment in order to earn outrageous bonuses. Lastly, we now understand that the central banks have woefully outdated tools to deal with all the financial innovations—credit debt obligations, mortgage-backed securities, off balance sheet obligations, structured investment vehicles, derivative products—and hybrid financial institutions that have evolved since these regulatory bodies were created.

Originally published in the Sarasota Herald-Tribune