Accounting scandals

Accounting scandals, or corporate accounting scandals,

are political and business scandals which arise with the disclosure of misdeeds by
trusted executives of large public corporations. Such misdeeds typically involve
complex methods for misusing or misdirecting funds, overstating revenues,
understating expenses, overstating the value of corporate assets or underreporting
the existence of liabilities, sometimes with the cooperation of officials in other
corporations or affiliates.

In public companies, this type of "creative accounting" can amount to fraud and
investigations are typically launched by government oversightagencies, such as
the Securities and Exchange Commission (SEC) in the United States.

Unfortunately, scandals are often only the 'tip of the iceberg'. They represent the
visible catastrophic failures. Note that much abuse can be completely legal or quasi
legal.

For example, in the domain of privatization and takeovers :

It is fairly easy for a top executive to reduce the price of his/her company's stock -
due to information asymmetry. The executive can accelerate accounting of expected
expenses, delay accounting of expected revenue, engage in off balance
sheet transactions to make the company's profitability appear temporarily poorer, or
simply promote and report severely conservative (eg. pessimistic) estimates of future
earnings. Such seemingly adverse earnings news will be likely to (at least
temporarily) reduce share price. (This is again due to information asymmetries since
it is more common for top executives to do everything they can to window dress their
company's earnings forecasts). There are typically very few legal risks to being 'too
conservative' in one's accounting and earnings estimates.

A reduced share price makes a company an easier takeover target. When the
company gets bought out (or taken private) - at a dramatically lower price - the
takeover artist gains a windfall from the former top executive's actions to
surreptitiously reduce share price. This can represent tens of billions of dollars
(questionably) transferred from previous shareholders to the takeover artist. The
former top executive is then rewarded with a golden handshake for presiding over
the firesale that can sometimes be in the hundreds of millions of dollars for one or
two years of work. (This is nevertheless an excellent bargain for the takeover artist,
who will tend to benefit from developing a reputation of being very generous to
parting top executives).

Similar issues occur when a publicly held asset or non-profit

organization undergoes privatization. Top executives often reap tremendous
monetary benefits when a government owned or non-profit entity is sold to private
hands. Just as in the example above, they can facilitate this process by making the
entity appear to be in financial crisis - this reduces the sale price (to the profit of the
purchaser), and makes non-profits and governments more likely to sell. Ironically, it
can also contribute to a public perception that private entities are more efficiently run
reinforcing the political will to sell off public assets. Again, due to asymmetric
information, policy makers and the general public see a government owned firm that
was a financial 'disaster' - miraculously turned around by the private sector (and
typically resold) within a few years.

]Notable accounting scandals

Company Year Audit Firm Country Notes

Nugan Hand Bank 1980[1] Australia

United Ponzi scheme run by Barry

ZZZZ Best 1986[2]
States Minkow

United Gilts management service. 110

Barlow Clowes 1988[3]
Kingdom million missing

United
MiniScribe 1989[4]
States

United
Polly Peck 1990[5]
Kingdom
Bank of Credit and
United
Commerce 1991[6]
Kingdom
International

United
Phar-Mor 1992[7]
States

United
Informix 1996[8]
States

United
Cendant 1998[9] Ernst & Young
States

Waste United
1999[10] Financial mistatements
Management, Inc. States

PricewaterhouseCoope United
Microstrategy 2000[11] Michael Saylor
rs States

United
Unify Corporation 2000[12]
States

Computer United
2000[13] KPMG Sanjay Kumar
Associates States

United
Xerox 2000[14] KPMG Falsifying financial results
States

One.Tel 2001[15] Ernst & Young Australia

United Jeffrey Skilling, Kenneth

Enron 2001[16] Arthur Andersen
States Lay, Andrew Fastow

United
Adelphia 2002[17] Deloitte & Touche John Rigas
States
 United
AOL 2002[14] Ernst & Young Inflated sales
States

Bristol-Myers PricewaterhouseCoope United

2002[14][18] Inflated revenues
Squibb rs States

United
CMS Energy 2002[14][19] Arthur Andersen Round trip trades
States

United
Duke Energy 2002[14] Deloitte & Touche Round trip trades
States

United
Dynegy 2002[14] Arthur Andersen Round trip trades
States

El Paso United
2002[14] Deloitte & Touche Round trip trades
Corporation States

United
Freddie Mac 2002[20] Understated earnings
States

Network capacity swaps to inflate

Global Crossing 2002[14] Arthur Andersen Bermuda
revenues

United
Halliburton 2002[14] Arthur Andersen Improper booking of cost overruns
States

United
Homestore.com 2002[14][21] Improper booking of sales
States

United
ImClone Systems 2002[22] KPMG Samuel D. Waksal
States

PricewaterhouseCoope United
Kmart 2002[14][23] Misleading accounting practices
rs States
 United Recorded co-payments that were
Merck & Co. 2002[14]
States not collected

United
Merrill Lynch 2002[24] Deloitte & Touche Conflict of interest
States

United
Mirant 2002[14] Overstated assets and liabilities
States

United Overstated assets, understated

Nicor 2002[14]
States liabilities

United
Peregrine Systems 2002[14] KPMG Overstated sales
States

Qwest United
2002[14] Inflated revenues
Communications States

United
Reliant Energy 2002[14] Deloitte & Touche Round trip trades
States

United
Sunbeam 2002[25]
States

PricewaterhouseCoope Improper accounting, Dennis

Tyco International 2002[14] Bermuda
rs Kozlowski

United Overstated cash flows, Bernard

WorldCom 2002[14] Arthur Andersen
States Ebbers

Royal Ahold 2003[26] Deloitte & Touche Netherlands Inflating promotional allowances

Falsified accounting
Parmalat 2003[27][28] Grant Thornton SpA Italy
documents, Calisto Tanzi
HealthSouth United
2003[29] Ernst & Young Richard M. Scrushy
Corporation States

Chiquita Brands United

2004[30] Illegal payments
International States

PricewaterhouseCoope United Accounting of structured financial

AIG 2004[31]
rs States deals

Ponzi scheme run by Bernard

Madoff. David G. Friehling was
charged with securities fraud,
aiding and abetting investment
Bernard L. Madoff adviser fraud, and four counts of
United
Investment 2008[32] Friehling & Horowitz filing false audit reports with the
States
Securities LLC Securities and Exchange
Commission in regards to this
Ponzi scheme. He faces up to 105
years in prison on all of the
charges.[33]

Satyam Computer PricewaterhouseCoope

2009[34] India Falsified accounts
Services rs

Notable outcomes

The Enron scandal resulted in the indictment and criminal conviction of the Big Five
auditor Arthur Andersen on June 15, 2002. Although the conviction was overturned on
May 31, 2005 by the Supreme Court of the United States, the firm ceased performing
audits and is currently unwinding its business operations.

On July 9, 2002 George W. Bush gave a speech about recent accounting scandals that
have been uncovered. In spite of its stern tone, the speech did not focus on
establishing new policy, but instead focused on actually enforcing current laws, which
include holding CEOs and directors personally responsible for accountancy fraud.

In July, 2002, WorldCom filed for bankruptcy protection, in what was considered the
largest corporate insolvency ever at the time.
These scandals reignited the debate over the relative merits of US GAAP, which takes
a "rules-based" approach to accounting, versusInternational Accounting
Standards and UK GAAP, which takes a "principles-based" approach. The Financial
Accounting Standards Boardannounced that it intends to introduce more principles-
based standards. More radical means of accounting reform have been proposed, but
so far have very little support. The debate itself, however, overlooks the difficulties of
classifying any system of knowledge, including accounting, as rules-based or
principles-based.

On a lighter note, the 2002 Ig Nobel Prize in Economics went to the CEOs of those
companies involved in the corporate accounting scandals of that year for "adapting
the mathematical concept of imaginary numbers for use in the business world".

In 2005, after a scandal on insurance and mutual funds the year before, AIG is under
investigation for accounting fraud. The company already lost over 45 billion US
dollars worth of market capitalisation because of the scandal. This was the fastest
decrease since the WorldCom andEnron scandals. Investigations also discovered over
a billion US dollars worth of errors in accounting transactions. Future outcome for the
company is still pending.

Satyam scandal
The Satyam Computer Services scandal was publicly announced on 7 January
2009, when Chairman Ramalinga Raju confessed that Satyam's accounts had been
falsified.

Details

On 7 January 2009, company Chairman Ramalinga Raju resigned after notifying board
members and the Securities and Exchange Board of India (SEBI) that Satyam's
accounts had been falsified [1][2][3]
.

Raju confessed that Satyam's balance sheet of 30 September 2008 contained:

inflated figures for cash and bank balances of Rs 5,040 crore (US$ 1.04
billion) (as against Rs 5,361 crore (US$ 1.1 billion) crore reflected in the books).
 an accrued interest of Rs. 376 crore (US$ 77.46 million) which was non-
existent.
an understated liability of Rs. 1,230 crore (US$ 253.38 million) on account of
funds was arranged by himself.
an overstated debtors' position of Rs. 490 crore (US$ 100.94 million) (as
against Rs. 2,651 crore (US$ 546.11 million) in the books).

Raju claimed in the same letter that neither he nor the managing director had
benefited financially from the inflated revenues. He claimed that none of the board
members had any knowledge of the situation in which the company was placed. [4] [5]

He stated that

"What started as a marginal gap between actual operating profit and the one reflected in the
books of accounts continued to grow over the years. It has attained unmanageable proportions
as the size of company operations grew significantly (annualised revenue run rate ofRs 11,276
crore (US$ 2.32 billion) in the September quarter of 2008 and official reserves of Rs 8,392 crore
(US$ 1.73 billion)). As the promoters held a small percentage of equity, the concern was that
poor performance would result in a takeover, thereby exposing the gap. The aborted Maytas
acquisition deal was the last attempt to fill the fictitious assets with real ones. It was like riding
a tiger, not knowing how to get off without being eaten.***

Aftermath

Raju had appointed a task force to address the Maytas situation in the last few days
before revealing the news of the accounting fraud. After the scandal broke, the then-
board members elected Ram Mynampati to be Satyam's interim CEO. Mynampati's
statement on Satyam's website said:

"We are obviously shocked by the contents of the letter. The senior leaders of Satyam stand
united in their commitment to customers, associates, suppliers and all shareholders. We have
gathered together at Hyderabad to strategize the way forward in light of this startling
revelation."
On 10 January 2009, the Company Law Board decided to bar the current board of
Satyam from functioning and appoint 10 nominal directors. "The current board has
failed to do what they are supposed to do. The credibility of the IT industry should not
be allowed to suffer." said Corporate Affairs Minister Prem Chand Gupta. Chartered
accountants regulator ICAI issued show-cause notice to Satyam's
auditorPricewaterhouseCoopers (PwC) on the accounts fudging. "We have asked PwC
to reply within 21 days," ICAI President Ved Jain said.

On the same day, the Crime Investigation Department (CID) team picked up
Vadlamani Srinivas, Satyam's then-CFO, for questioning. He was arrested later and
kept in judicial custody[6].

On 11 January 2009, the government nominated noted banker Deepak Parekh,

former NASSCOM chief Kiran Karnik and former SEBI memberC Achuthan to Satyam's
board.

Analysts in India have termed the Satyam scandal as India's own Enron scandal.[7].
Some social commentators see it as more endemic problem arising from its caste
based, family owned capitalist structure (http://kafila.org/2009/02/13/the-caste-of-a-
scam-a-thousand-satyams-in-the-making/)

Immediately following the news, Merrill Lynch (Now with Bank of America) terminated
its engagement with the company. Also, Credit Suissesuspended its coverage of
Satyam.[citation needed]. It was also reported that Satyam's auditing firm
PricewaterhouseCoopers will be scrutinized for complicity in this scandal. SEBI, the
stock market regulator, also said that, if found guilty, its license to work in India may
be revoked.[8][9][10][11][12] Satyam was the 2008 winner of the coveted Golden Peacock
Award for Corporate Governance under Risk Management and Compliance Issues,
[13]
which was stripped from them in the aftermath of the scandal. [14] The New York
Stock Exchange has halted trading in Satyam stock as of 7 January 2009.
[15]
India's National Stock Exchange has announced that it will remove Satyam from
its S&P CNX Nifty 50-share index on January 12.[16]The founder of Satyam was
arrested two days after he admitted to falsifying the firm's accounts. Ramalinga
Raju is charged with several offences, including criminal conspiracy, breach of trust,
and forgery.

Satyam's shares fell to 11.50 rupees on 10 January 2009, their lowest level
since March 1998, compared to a high of 544 rupees in 2008[17]. InNew York Stock
Exchange Satyam shares peaked in 2008 at US$ 29.10; by March 2009 they were
trading around US $1.80.

The Indian Government has stated that it may provide temporary direct or indirect
liquidity support to the company. However, whether employment will continue at pre-
crisis levels, particularly for new recruits, is questionable [18]
.

On 14 January 2009, Price Waterhouse, the Indian division

of PricewaterhouseCoopers, announced that its reliance on potentially false
information provided by the management of Satyam may have rendered its audit
reports "inaccurate and unreliable"[19].

On 22 January 2009, CID told in court that the actual number of employees is only
40,000 and not 53,000 as reported earlier and that Mr. Raju had been allegedly
withdrawing INR 20 crore rupees every month for paying these 13,000 non-existent
employees [20]
.

New CEO and special advisors

On 5th February 2009, the six-member board appointed by the Government

of India named A. S. Murthy as the new CEO of the firm with immediate effect.
Murthy, an electrical engineer, has been with Satyam since January 1994 and was
heading the Global Delivery Section before being appointed as CEO of the company.
The two-day-long board meeting also appointed Homi Khusrokhan (formerly with Tata
Chemicals) and Partho Datta, a Chartered Accountant as special advisors [21] [22]
.

After the 2009 Satyam accounting scandal

After B Ramalinga Raju admitted to committing a fraud, the Maytas stock slumped to
a 52-week low on 9 January 2009.[4]

In wake of the Satyam scam, the Citizens for a Better Public Transport in Hyderabad
(CBPTH) demanded a CBI inquiry into the process of how Maytas bagged the
Hyderabad Metro Rail project. The CBPTH convener C Ramachandraiah alleged that
the state government had been favouring Maytas for infrastructure projects. [5] The
Economic Times reported that the Andhra Pradesh government has had paid Rs.
1,800 crore to Maytas Infra towards works under the irrigation department's
Jalayagnam project. The major irrigation minister Ponnala Lakshmaiah said that works
totalling another Rs 11,000 crore had been sanctioned to Maytas Infra, since Y S
Rajasekhara Reddy took as the chief minister in 2004.[6] Maytas Infra-led consortium
failed to achieve financial closure and give performance guarantee, the state
government of Andhra Pradesh was on Tuesday forced to end its unprecedented
generosity and cancel the concession agreement with the group on the Rs 12,132-
crore Hyderabad Metro Rail project.[7] On July 21, 2009, a criminal case was registered
against the promoters of the company by the Hyderabadpolice under Section 406
(criminal breach of trust) and Section 420 (cheating) of the Indian Penal Code[8]
Credit rating agency
From Wikipedia, the free encyclopedia

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of
certain types of debtobligations as well as the debt instruments themselves. In some
cases, the servicers of the underlying debtare also given ratings. In most cases, the
issuers of securities are companies, special purpose entities, state and local
governments, non-profit organizations, or national governments issuing debt-like
securities (i.e.,bonds) that can be traded on a secondary market. A credit rating for
an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay
back a loan), and affects the interest rate applied to the particular security being
issued. (In contrast to CRAs, a company that issues credit scores for individual credit-
worthiness is generally called a credit bureau or consumer credit reporting agency.)
The value of such ratings has been widely questioned after the 2008 financial crisis.
In 2003 the Securities and Exchange Commission submitted a report to Congress
detailing plans to launch an investigation into the anti-competitive practices of credit
rating agencies and issues including conflicts of interest. [1]

Credit rating agencies for corporations &

government entities
For more information, see Bond credit rating.

Agencies that assign credit ratings for corporations include:

A. M. Best (U.S.)
Baycorp Advantage (Australia)
Dominion Bond Rating Service (Canada)
China Credit Information Service (China)
Fitch Ratings (U.S.)
Japan Credit Rating Agency (Japan)
Moody's Investors Service (U.S.)
 Standard & Poor's (U.S.)
Rating Agency Malaysia (Malaysia)
Egan-Jones Rating Company (U.S.)

[edit]Uses of ratings

Credit ratings are used by investors, issuers, investment banks, broker-dealers, and
governments. For investors, credit rating agencies increase the range of investment
alternatives and provide independent, easy-to-use measurements of relative credit
risk; this generally increases the efficiency of the market, lowering costs for
both borrowers and lenders. This in turn increases the total supply of risk capital in
the economy, leading to stronger growth. It also opens the capital markets to
categories of borrower who might otherwise be shut out altogether: small
governments, startup companies, hospitals, and universities.

[edit]Ratings use by bond issuers

Issuers rely on credit ratings as an independent verification of their own credit-
worthiness and the resultant value of the instruments they issue. In most cases, a
significant bond issuance must have at least one rating from a respected CRA for the
issuance to be successful (without such a rating, the issuance may be
undersubscribed or the price offered by investors too low for the issuer's purposes).
Studies by the Bond Market Association note that many institutional investors now
prefer that a debt issuance have at least three ratings.

Issuers also use credit ratings in certain structured finance transactions. For example,
a company with a very high credit rating wishing to undertake a particularly risky
research project could create a legally separate entity with certain assets that would
own and conduct the research work. This "special purpose entity" would then assume
all of the research risk and issue its own debt securities to finance the research. The
SPE's credit rating likely would be very low, and the issuer would have to pay a high
rate of return on the bonds issued. However, this risk would not lower the parent
company's overall credit rating because the SPE would be a legally separate entity.
Conversely, a company with a low credit rating might be able to borrow on better
terms if it were to form an SPE and transfer significant assets to that subsidiary and
issue secured debt securities. That way, if the venture were to fail, the lenders would
have recourse to the assets owned by the SPE. This would lower the interest rate the
SPE would need to pay as part of the debt offering.
The same issuer also may have different credit ratings for different bonds. This
difference results from the bond's structure, how it is secured, and the degree to
which the bond is subordinated to other debt. Many larger CRAs offer "credit rating
advisory services" that essentially advise an issuer on how to structure its bond
offerings and SPEs so as to achieve a given credit rating for a certain debt tranche.
This creates a potential conflict of interest, of course, as the CRA may feel obligated
to provide the issuer with that given rating if the issuer followed its advice on
structuring the offering. Some CRAs avoid this conflict by refusing to rate debt
offerings for which its advisory services were sought.

[edit]Ratings use by government regulators

Regulators use credit ratings as well, or permit ratings to be used for regulatory
purposes. For example, under the Basel II agreement of theBasel Committee on
Banking Supervision, banking regulators can allow banks to use credit ratings from
certain approved CRAs (called "ECAIs", or "External Credit Assessment Institutions")
when calculating their net capital reserve requirements. In the United States,
theSecurities and Exchange Commission (SEC) permits investment banks and broker-
dealers to use credit ratings from "Nationally Recognized Statistical Rating
Organizations" (or "NRSROs") for similar purposes. The idea is that banks and other
financial institutions should not need to keep in reserve the same amount
of capital to protect the institution against (for example) a run on the bank, if the
financial institution is heavily invested in highly liquid and very "safe" securities (such
as U.S. government bonds or short-term commercial paper from very stable
companies).

CRA ratings are also used for other regulatory purposes as well. The US SEC, for
example, permits certain bond issuers to use a shortenedprospectus form when
issuing bonds if the issuer is older, has issued bonds before, and has a credit rating
above a certain level. SEC regulations also require that money market funds (mutual
funds that mimic the safety and liquidity of a bank savings deposit, but
without FDICinsurance) comprise only securities with a very high NRSRO rating.
Likewise, insurance regulators use credit ratings to ascertain the strength of the
reserves held by insurance companies.

Under both Basel II and SEC regulations, not just any CRA's ratings can be used for
regulatory purposes. (If this were the case, it would present an obvious moral hazard,
since an issuer, insurance company, or investment bank would have a strong
incentive to seek out a CRA with the most lax standards, with potentially dire
consequences for overall financial stability.) Rather, there is a vetting process of
varying sorts. The Basel II guidelines (paragraph 91, et al.), for example, describe
certain criteria that bank regulators should look to when permitting the ratings from a
particular CRA to be used. These include "objectivity," "independence,"
"transparency," and others. Banking regulators from a number of jurisdictions have
since issued their own discussion papers on this subject, to further define how these
terms will be used in practice. (See The Committee of European Banking Supervisors
Discussion Paper, or the State Bank of Pakistan ECAI Criteria.)

In the United States, since 1975, NRSRO recognition has been granted through a "No
Action Letter" sent by the SEC staff. Following this approach, if a CRA (or investment
bank or broker-dealer) were interested in using the ratings from a particular CRA for
regulatory purposes, the SEC staff would research the market to determine whether
ratings from that particular CRA are widely used and considered "reliable and
credible." If the SEC staff determines that this is the case, it sends a letter to the CRA
indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff
will not recommend enforcement action against that entity. These "No Action" letters
are made public and can be relied upon by other regulated entities, not just the
entity making the original request. The SEC has since sought to further define the
criteria it uses when making this assessment, and in March 2005 published a
proposed regulation to this effect.

On September 29, 2006, US President George W. Bush signed into law the "Credit
Rating Reform Act of 2006".[2] This law requires the US Securities and Exchange
Commission to clarify how NRSRO recognition is granted, eliminates the "No Action
Letter" approach and makes NRSRO recognition a Commission (rather than SEC staff)
decision, and requires NRSROs to register with, and be regulated by, the
SEC.S & P protested the Act on the grounds that it is an unconstitutional violation
of freedom of speech.[2] In the Summer of 2007 the SEC issued regulations
implementing the act, requiring rating agencies to have policies to prevent misuse of
nonpublic information, disclosure of conflicts of interest and prohibitions against
"unfair practices".[3]

Recognizing CRAs' role in capital formation, some governments have attempted to

jump-start their domestic rating-agency businesses with various kinds of regulatory
relief or encouragement. This may, however, be counterproductive, if it dulls the
market mechanism by which agencies compete, subsidizing less-capable agencies
and penalizing agencies that devote resources to higher-quality opinions.

[edit]Ratings use in structured finance

Credit rating agencies may also play a key role in structured financial transactions.
Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certain
return on a loan, structured financial transactions may be viewed as either a series of
loans with different characteristics, or else a number of small loans of a similar type
packaged together into a series of "buckets" (with the "buckets" or different loans
called "tranches"). Credit ratings often determine the interest rate or price ascribed
to a particular tranche, based on the quality of loans or quality of assets contained
within that grouping.

Companies involved in structured financing arrangements often consult with credit

rating agencies to help them determine how to structure the individual tranches so
that each receives a desired credit rating. For example, a firm may wish to borrow a
large sum of money by issuing debt securities. However, the amount is so large that
the return investors may demand on a single issuance would be prohibitive. Instead,
it decides to issue three separate bonds, with three separate credit ratingsA
(medium low risk), BBB (medium risk), and BB (speculative) (using Standard & Poor's
rating system). The firm expects that the effective interest rate it pays on the A-rated
bonds will be much less than the rate it must pay on the BB-rated bonds, but that,
overall, the amount it must pay for the total capital it raises will be less than it would
pay if the entire amount were raised from a single bond offering. As this transaction
is devised, the firm may consult with a credit rating agency to see how it must
structure each tranchein other words, what types of assets must be used
to secure the debt in each tranchein order for that tranche to receive the desired
rating when it is issued.

There has been criticism in the wake of large losses in the collateralized debt
obligation (CDO) market that occurred despite being assigned top ratings by the
CRAs. For instance, losses on $340.7 million worth of collateralized debt obligations
(CDO) issued by Credit Suisse Group added up to about $125 million, despite being
rated AAA or Aaa by Standard & Poor's, Moody's Investors Service and Fitch Group. [4]

The rating agencies respond that their advice constitutes only a "point in time"
analysis, that they make clear that they never promise or guarantee a certain rating
to a tranche, and that they also make clear that any change in circumstance
regarding the risk factors of a particular tranche will invalidate their analysis and
result in a different credit rating. In addition, some CRAs do not rate bond issuances
upon which they have offered such advice.

Complicating matters, particularly where structured finance transactions are

concerned, the rating agencies state that their ratings are opinions (and as such, are
protected free speech, granted to them by the "personhood" of corporations)
regarding the likelihood that a given debt security will fail to be serviced over a given
period of time, and not an opinion on the volatility of that security and certainly not
the wisdom of investing in that security. In the past, most highly rated (AAA or Aaa)
debt securities were characterized by low volatility and high liquidityin other words,
the price of a highly rated bond did not fluctuate greatly day-to-day, and sellers of
such securities could easily find buyers. However, structured transactions that
involve the bundling of hundreds or thousands of similar (and similarly rated)
securities tend to concentrate similar risk in such a way that even a slight change on
a chance of default can have an enormous effect on the price of the bundled security.
This means that even though a rating agency could be correct in its opinion that the
chance of default of a structured product is very low, even a slight change in the
market's perception of the risk of that product can have a disproportionate effect on
the product's market price, with the result that an ostensibly AAA or Aaa-rated
security can collapse in price even without there being any default (or significant
chance of default). This possibility raises significant regulatory issues because the
use of ratings in securities and banking regulation (as noted above) assumes that
high ratings correspond with low volatility and high liquidity.

[edit]Criticism

Credit rating agencies have been subject to the following criticisms:

Credit rating agencies do not downgrade companies promptly enough.

For example, Enron's rating remained at investment grade four days before the
company went bankrupt, despite the fact that credit rating agencies had been
aware of the company's problems for months.[5][6] Some empirical studies have
documented that yield spreads of corporate bonds start to expand as credit
quality deteriorates but before a rating downgrade, implying that the market
often leads a downgrade and questioning the informational value of credit ratings.
[7]
This has led to suggestions that, rather than rely on CRA ratings in financial
regulation, financial regulators should instead require banks, broker-dealers and
 insurance firms (among others) to use credit spreads when calculating the risk in
their portfolio.

Large corporate rating agencies have been criticized for having too familiar
a relationship with company management, possibly opening themselves to
undue influence or the vulnerability of being misled. [8] These agencies meet
frequently in person with the management of many companies, and advise on
actions the company should take to maintain a certain rating. Furthermore,
because information about ratings changes from the larger CRAs can spread so
quickly (by word of mouth, email, etc.), the larger CRAs charge debt issuers,
rather than investors, for their ratings. This has led to accusations that these
CRAs are plagued by conflicts of interest that might inhibit them from providing
accurate and honest ratings. At the same time, more generally, the largest
agencies (Moody's and Standard & Poor's) are often seen as agents
of globalization and/or "Anglo-American" market forces, that drive companies to
consider how a proposed activity might affect their credit rating, possibly at the
expense of employees, the environment, or long-term research and development.
These accusations are not entirely consistent: on one hand, the larger CRAs are
accused of being too cozy with the companies they rate, and on the other hand
they are accused of being too focused on a company's "bottom line" and unwilling
to listen to a company's explanations for its actions.

The lowering of a credit score by a CRA can create a vicious cycle, as not
only interest rates for that company would go up, but other contracts with
financial institutions may be affected adversely, causing an increase in expenses
and ensuing decrease in credit worthiness. In some cases, large loans to
companies contain a clause that makes the loan due in full if the companies'
credit rating is lowered beyond a certain point (usually a "speculative" or "junk
bond" rating). The purpose of these "ratings triggers" is to ensure that the bank is
able to lay claim to a weak company's assets before the company
declares bankruptcy and a receiver is appointed to divide up the claims against
the company. The effect of such ratings triggers, however, can be devastating:
under a worst-case scenario, once the company's debt is downgraded by a CRA,
the company's loans become due in full; since the troubled company likely is
incapable of paying all of these loans in full at once, it is forced into bankruptcy (a
so-called "death spiral"). These rating triggers were instrumental in the collapse
 of Enron. Since that time, major agencies have put extra effort into detecting
these triggers and discouraging their use, and the U.S. Securities and Exchange
Commission requires that public companies in the United States disclose their
existence.

Agencies are sometimes accused of being oligopolists,[9] because barriers to

market entry are high and rating agency business is itself reputation-based (and
the finance industry pays little attention to a rating that is not widely recognized).
Of the large agencies, only Moody's is a separate, publicly held corporation that
discloses its financial results without dilution by non-ratings businesses, and its
high profit margines (which at times have been greater than 50 percent of gross
margin) can be construed as consistent with the type of returns one might expect
in an industry which has high barriers to entry.

Credit Rating Agencies have made errors of judgment in rating

structured products, particularly in assigning AAA ratings to structured debt,
which in a large number of cases has subsequently been downgraded or
defaulted. This has led to problems for several banks whose capital requirements
depend on the rating of the structured assets they hold, as well as large losses in
the banking industry.[10][11][12] AAA rated mortgage securities trading at only 80
cents on the dollar, implying a greater than 20% chance of default, and 8.9% of
AAA rated structured CDOs are being considered for downgrade by Fitch, which
expects most to downgrade to an average of BBB to BB-. These levels of
reassessment are surprising for AAA rated bonds, which have the same rating
class as US government bonds.[13][14]. Most rating agencies do not draw a
distinction between AAA on structured finance and AAA on corporate or
government bonds (though their ratings releases typically describe the type of
security being rated). Many banks, such as AIG, made the mistake of not holding
enough capital in reserve in the event of downgrades to their CDO portfolio. The
structure of the Basel II agreements meant that CDOs capital requirement rose
'exponentially'. This made CDO portfolios vulnerable to multiple downgrades,
essentially precipitating a large margin call. For example under Basel II, a AAA
rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%,
a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation. For a
number of reasons (frequently having to do with inadequate staff expertise and
the costs that risk management programs entail), many institutional investors
 relied solely on the ratings agencies rather than conducting their own analysis of
the risks these instruments posed. (As an example of the complexity involved in
analyzing some CDOs, the Aquarius CDO structure has 51 issues behind the cash
CDO component of the structure and another 129 issues that serve as reference
entities for $1.4 billion in CDS contracts for a total of 180. In a sample of just 40 of
these, they had on average 6500 loans at origination. Projecting that number to
all 180 issues implies that the Aquarius CDO has exposure to about 1.2 million
loans.)

Ratings agencies, in particular Fitch, Moody's and Standard and Poors have
been implicitly allowed by the government to fill a quasi-regulatory role, but
because they are for-profit entities their incentives may be misaligned. Conflicts
of interest often arise because the rating agencies, are paid by the companies
issuing the securities an arrangement that has come under fire as a
disincentive for the agencies to be vigilant on behalf of investors. Many market
participants no longer rely on the credit agencies ratings systems, even before
the economic crisis of 2007-8, preferring instead to use credit spreads to
benchmarks like Treasuries or an index. However, since the Federal Reserve
requires that structured financial entities be rated by at least two of the three
credit agencies, they have a continued obligation.

Many of the structured financial products that they were responsible for
rating, consisted of lower quality 'BBB' rated loans, but were, when pooled
together into CDOs, assigned an AAA rating. The strength of the CDO was not
wholly dependent on the strength of the underlying loans, but in fact the
structure assigned to the CDO in question. CDOs are usually paid out in a
'waterfall' style fashion, where income received gets paid out first to the highest
tranches, with the remaining income flowing down to the lower quality tranches
i.e. <AAA. CDOs were typically structured such that AAA tranches which were to
receive first lien (claim) on the BBB rated loans cash flows, and losses would
trickle up from the lowest quality tranches first. Cash flow was well insulated even
against heavy levels of home owner defaults. Credit rating agencies only
accounted for a ~5% decline in national housing prices at worst, allowing for a
confidence in rating the many of these CDOs that had poor underlying loan
qualities as AAA. It did not help that an incestuous relationship between financial
institutions and the credit agencies developed such that, banks began to leverage
 the credit ratings off one another and 'shop' around amongst the three big credit
agencies until they found the best ratings for their CDOs. Often they would add
and remove loans of various quality until they met the minimum standards for a
desired rating, usually, AAA rating. Often the fees on such ratings were $300,000
- $500,000, but ran up to $1 million. [1]

As part of the Sarbanes-Oxley Act of 2002, Congress ordered the U.S. SEC to develop
a report, titled Report on the Role and Function of Credit Rating Agencies in the
Operation of the Securities Markets detailing how credit ratings are used in U.S.
regulation and the policy issues this use raises. Partly as a result of this report, in
June 2003, the SEC published a "concept release" called Rating Agencies and the Use
of Credit Ratings under the Federal Securities Laws that sought public comment on
many of the issues raised in its report. Public comments on this concept release have
also been published on the SEC's website.

In December 2004, the International Organization of Securities Commissions (IOSCO)

published a Code of Conduct for CRAs that, among other things, is designed to
address the types of conflicts of interest that CRAs face. All of the major CRAs have
agreed to sign on to this Code of Conduct and it has been praised by regulators
ranging from the European Commission to the U.S. Securities and Exchange
Commission