I have blogged before on the credit agency Egan-Jones’ recent downgrading of the credit quality of U.S. treasuries. It appears now that the SEC has gone after the credit rating agency and has recently banned Egan-Jones from rating any government-backed bonds or securities for the next 18 months. That is, the one credit agency that has begun to appropriately recognize the risk of the U.S. treasury has now been banned from rating the U.S. Treasury.
Let’s take a moment to step back and examine how the credit rating world work:
- Effectively, the government runs a cartel of credit rating agencies, requiring an agency to acquire a permit of certification before it is allowed to legally issue credit ratings on various bonds or securities. As required from the SEC in 1975, any company that wishes to rate debt must belong to the Nationally Recognized Statistical Rating Organization (NRSRO). This is an exclusive club and has contained anywhere from only five to seven member organizations, and therefore the ability to rate credit has become a monopoly power granted to only a few (and as we will see, willingly complicit) companies.
- In the aftermath of the creation of the NRSRO, most credit rating agencies transitioned away from being paid by the consumers/users of the credit score toward the practice of being paid by the issuers of the debt. Let me explain: previously those who were interested in being debt buyers would essentially purchase from the rating agency their opinion of the creditworthiness of a particular bond, and use that information in determining the risk of default. In this way, a credit agency’s ability to correctly assess the risks associated with a particular bond directly affected its reputation. There was a obvious incentive for each credit agency to rate debt honesly because those with good track records attracted more clients. The new method works in quite the opposite way. Instead of being paid by the consumers of the information, most credit agencies are now paid by the ISSUERS of the debt. This allows issuers to “shop-around” various rating agencies to find which one will rate it most favorably. The change in the incentive structure should be obvious: instead of ensuring that consumers were getting the most accurate information regarding the creditworthiness of a bond, credit agencies could now afford to sacrifice the accuracy of their rating in order to procure a better price from the issuer.
Now, back to Egan-Jones. While a small and relatively unknown rating agency (especially compared to the “big three”: S&P, Moody’s, and Fitch) Egan-Jones is one of the select few members of the government credit rating cartel. However, unlike its larger competitors, it never transitioned to the issuer-paid method of rating debt. In maintaining its independence from the issuers money, it has maintained its ability to issue honest and unbiased opinions on the debt it rates. It is because of this practice that Egan-Jones has been able to downgrade U.S. Treasuries multiple times over the past few years to its current level of AA – .
It seems, however, that the government has finally taken enough from this small scale rating agency, and has now alleged that the firm filed inaccurate documents with regulators in 2008 to “mislead” customers. In neither admitting or denying the accusations, Egan-Jones reached a settlement with the SEC banning it from rating bonds issued by countries, U.S. states and local governments, or securities backed by assets such as mortgages for at least the next 18 months.
What should be of interest is that the government has not gone after any of the other rating agencies that rated as AAA mortgage-backed securities that eventually went to zero back in the depths of the financial crisis. Certainly there was nothing “misleading” about these ratings of securities issued by the federal government. I am sure that is a pure coincidence that the only credit agency targeted by the SEC is the one that has continuously downgraded U.S. debt.
The bottom line is this: don’t mess with the reputation of the solvency of the federal government, and if you do, expect to face the strong arm of the SEC and the government’s cartel.