The first time I wrote about Sean Egan and his small, independent credit-research firm, Egan-Jones Ratings Co., was in December 2007 for a column about the bond insurer MBIA Inc. And man, did he nail it.
The three big credit raters -- Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings -- all had AAA ratings on MBIA’s insurance unit, their highest grade. Egan said it deserved much lower. Anyone reading MBIA’s financial reports could see the company was losing money and needed billions of dollars of fresh capital.
By mid-2008, the Big Three had cut their ratings. Once again, Egan, a lonely voice of reason who saw the financial crisis coming, had shown his larger competitors to be incompetent or compromised. It was one of many great calls to come for Egan-Jones. As for MBIA, which had no revenue last quarter, it’s still struggling.
So if you had told me back then that the Securities and Exchange Commission’s enforcement division more than four years later would be accusing Egan, and his firm, of securities-law violations -- but not any of the big rating companies -- there’s no way I would have believed you. That’s what happened this week, though.
Getting a Pass
Life isn’t fair, as they say. The big raters, which are paid by the issuers of securities they grade, so far have gotten a pass, even after helping cause the financial crisis by slapping AAA scores on countless tranches of subprime-mortgage dreck. Egan-Jones, with fewer than 20 employees, makes its money by selling subscriptions to investors, meaning it’s not beholden to issuers. Yet Egan and his firm are getting pinched, although nothing in the SEC’s administrative complaint indicates investors were harmed.
None of this is to excuse any infractions Egan-Jones might have committed. We will have to wait and see if the agency’s claims stick in court. That said, it seems Egan-Jones’s big mistake was to seek formal recognition from the SEC at all.
The allegations mainly concern the application Egan-Jones filed with the agency in 2008 to expand its license as a so-called nationally recognized statistical rating organization. The firm, based in Haverford, Pennsylvania, first received that designation in 2007 for rating corporate debt, insurance companies and banks. Its 2008 application, which the SEC approved, sought recognition as a rater of asset-backed securities and government bonds.
Egan-Jones at the time said it had about 150 ratings on issuers of asset-backed securities and about 50 on government-debt issuers. The complaint said those numbers were overstated and that the firm hadn’t made any such ratings publicly available. Attorneys for Egan, 54, and the firm say their clients filled out the SEC’s application in good faith based on their understanding of what the form required.
Additionally, the complaint accused Egan-Jones of committing numerous book-and-record violations, such as failing to maintain a system for retaining employee e-mails. It also said the firm let two analysts participate in determining ratings for companies in which they owned securities, in violation of agency rules. An attorney for the defendants, Alan Futerfas, said the claims are without merit and that “the hypertechnical complaints that the SEC has alleged in no way justify an enforcement proceeding.”
What about the big rating companies? McGraw-Hill Cos., S&P’s parent, in September said the SEC’s staff had issued S&P a “Wells notice” warning that the agency may seek penalties over its rating of a $1.6 billion collateralized debt obligation in 2007. S&P received its letter the month before Egan got its Wells notice. There’s no telling if the SEC will follow through.
Join the Club
In 2010, the SEC issued an investigative report that said a Moody’s rating committee in 2007 knowingly decided to keep inflated ratings on about $1 billion of complex notes after discovering an error in one of the firm’s models. Later in 2007, Moody’s applied to the SEC for national recognition, under the same 2006 federal law on credit raters that Egan-Jones saw as its chance to join the same club as the Big Three.
The rating process used by Moody’s in that instance violated the policies described in the company’s application, the SEC said. However, the report said the agency decided not to accuse Moody’s of violating any laws, because some of the conduct occurred outside the U.S., presenting jurisdictional hurdles. Lucky break, I guess.
Egan-Jones isn’t the only credit rater where the SEC has identified problems related to employees’ investments. In a report last September, the SEC’s staff said it found that “each of the three larger NRSROs and four of the smaller NRSROs appeared to have some weaknesses with respect to their employee securities ownership policies and procedures.” (In September 2010, the SEC reached a settlement with another small credit-ratings company, Lace Financial Corp., over allegations of misstatements in its application for SEC recognition.)
The way Congress and the SEC have rigged this game, nationally recognized credit raters are a unique species of opinion merchants, endowed with sweeping authority and special privileges. Institutional money managers often are required by law to abide by their judgments. The better approach would be to scrap the designation, so investors are encouraged to do their own homework, rather than use credit ratings mindlessly.
Egan-Jones, which has been in business since 1992, could have continued operating as an independent publisher of ratings and analysis, not subject to government oversight or control. Instead it chose to play within the Big Three’s system, exposing itself to regulation and the whims of the SEC in exchange for the government’s imprimatur. Now it’s paying the price.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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