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 last week, though.
Life isn’t fair, as they say. The big raters, 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 oodles 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 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’ mistake was to seek 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, Pa., 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 free online credit report. Attorneys for Egan, 54, and the firm say their clients filled out the SEC’s application 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 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.
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.
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 notes after discovering an error in one of the firm’s models. Later in 2007, Moody’s applied to the SEC for recognition under the same 2006 federal law 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.
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.
Egan-Jones, which has been in business since 1992, could have continued as an independent, not subject to government oversight or control. Instead it chose to play within the Big Three’s system, exposing itself to the whims of the SEC. Now it’s paying the price.
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