Martin D. Weiss, Ph.D. | Saturday, May 10, 2014 at 7:30 am
It’s one that few advisors talk about and most investors don’t even think about: The conflicts, bias, payola, cover-ups and scams behind most Wall Street ratings assigned to hundreds of thousands of companies, bonds, stocks, and investments of all kinds.
Wall Street’s ratings are the brains and nervous system of the global financial markets; and those markets, in turn, are the heartbeat of the global economy.
So when the integrity of the ratings is compromised, it creates extra risks for everyone — individual investors, professional investors and even non-investors.
The reason is simple: If something is overrated, it is overpriced. It attracts buyers who think it’s a good investment. But as soon as the naked truth is revealed or the inflated rating is deeply downgraded, investors run in panic; and the resulting price declines can deliver wipe-out losses.
This could be one of the greatest silent killers in your portfolio. And whether you use ratings or not, it’s essential that you fully understand how it came about and how you can avoid the risks.
My experience with this sorry saga begins in the late 1980s. I had been rating the safety of the nation’s banks for over a decade, and my father, Irving Weiss, was an octogenarian.
One afternoon I told him our Weiss Ratings division was planning to start rating insurance companies.
I showed him some industry charts on my computer screen and asked his opinion.
“Check out First Executive (the parent of Executive Life Insurance),” he said.” Fred Carr’s running it — the guy they literally kicked out of Wall Street a few years ago. He’s trouble, and he’s knee deep in junk bonds. Follow the junk and you will find your answers.”
We did. We bought the entire database of insurance companies that had recently been made available for the first time by the National Association of Insurance Commissioners.
We built a computer model free of bias either for or against the companies.
And we found quite a few life insurance companies that were loaded with junk bonds, one of which was First Capital Life, to which I gave a D- rating. I was generous. The company should have gotten an F.
But within days of my widely publicized warnings on First Capital Life, a gaggle of the company’s lawyers and top executives flew down to our office. They ranted. They raved. They swore they’d slap me with a massive lawsuit and put me out of business if I didn’t give them a better rating.
“All the Wall Street ratings agencies give us high grades,” they said. “Who the hell do you think youare?”
I politely explained that I never let personal threats affect my ratings. And unlike other rating agencies, I don’t accept a dime from the companies I rate.
“I work for individuals,” I said, “not big corporations. Besides,” I continued, opening up the company’s most recent quarterly report, “your own financial statements prove your company is in trouble.”
Insurance company executive:
“Weiss better shut the @!%# up!”
That’s when one of them delivered the ultimate threat: “Weiss better shut the @!%# up,” he whispered to my associate, “or get a bodyguard.”
I did neither. To the contrary, I intensified my warnings. And within weeks, the company went belly-up just as I’d warned — still boasting high ratings from major Wall Street firms on the very day it failed.
In fact, the leading insurance rating agency, A.M. Best, didn’t downgrade First Capital Life to a warning level until 5 days after it failed. Needless to say, it was too late for policyholders.
It was a grisly sight — not just for policyholders, but for shareholders as well: The company’s stock crashed 99 percent, crucifying millions of unwitting investors. Then the stock died, wiped off the face of the earth.
Three of the company’s closest competitors also bit the dust. Unwitting investors — who did not have access to my ratings — lost $4 billion, $4.5 billion, and $13 billion, respectively.
Fortunately, those who had seen my ratings were ready. We warned them long before these companies went bust. Nobody who heeded our warning lost a cent.
In fact, the contrast between anyone who relied on our ratings and anyone who didn’t was so stark, even the U.S. Congress couldn’t help but notice. They asked: How was it possible for Weiss — a small firm in Florida — to identify companies that were about to fail, when Wall Street told us they were still “superior” or “excellent” right up to the day they failed?
To find an answer, Congress called all the rating agencies — S&P, Moody’s, A.M. Best, Duff & Phelps (now part of Fitch) and Weiss Research — to testify.
Three years later, after extensive research and review, the GAO published its conclusion: Weiss beat its leading competitor, A.M. Best, by a factor of three to one in forecasting future financial troubles. The three other Wall Street firms weren’t even competition.
But the GAO never answered
the original question — WHY?
I can assure you it wasn’t because of better access to information than our competitors. Nor were we smarter than they were. The real answer was contained in one four-letter word — bias.
To this day, the other rating agencies are paid huge fees by the companies for the ratings; their ratings are literally bought and paid for by the companies they rate.
These conflicts and bias in the ratings business are no trivial matter. To make money in today’s investment world — and to avoid unexpected losses — you must understand them. And you must know how to sidestep them.
In fact, I feel this is so important, I have decided to dedicate a three-part series to the subject, dedicating today’s to one of four ratings fiascos of modern history …
Ratings Fiasco #1
How Deceptive Ratings Entrapped 1.9
Million Americans in Failed Insurance
In the early 1980s, insurance companies had guaranteed to pay high yields to investors of 10 percent or more, but the best they could earn on safe bonds was 8, 7 or 6 percent. They had to do something to bridge that gap — and quickly. So how do you deliver high guaranteed yields when interest rates are going down?
Their solution: Buy the bonds of financially weaker companies.
Consider, for a moment, what bonds are and you’ll understand the situation. When you buy a bond, all you’re doing, in essence, is making a loan. If you make the loan to a strong, secure borrower, you won’t be able to collect a very high rate of interest. If you want a truly high interest rate, you need to take the risk of lending your money to a borrower that’s riskier — maybe a start-up company, or perhaps a company that’s had some financial difficulties.
What’s secure and what’s risky? In the corporate bond world, everyone has generally agreed to use the standard rating scales established by the two leading bond rating agencies — Moody’s and Standard & Poor’s. The two agencies use slightly different letters, but their scale is basically the same — triple-A, double-A, single-A … triple-B, double-B, single-B … etc.
If a bond is triple-B or better, it’s investment grade, relatively secure. If the bond is double-B or lower, it’s speculative grade. It’s not garbage you’d throw into the trash can. But in the parlance of Wall Street, it is officially known as junk. And that’s what many life insurance companies started to buy in the 1980s — junk.
They bought double-B bonds. They bought single-B bonds. They even bought unrated bonds that, if rated, would have been classified as junk.
Until this juncture, their high-risk strategy could be explained as a stop-gap solution to falling interest rates. But unbelievably, a few insurance companies — such as Executive Life of California, Executive Life of New York, Fidelity Bankers Life and First Capital Life — took the concept one giant step further: Their entire business plan was predicated on the concept of junk bonds from day one.
The key to their success was to keep the junk bond aspect hush-hush, while exploiting the faith people still had in the inherent safety of insurance.
But to make the scheme work, they needed two more elements: The blessing of the Wall Street ratings agencies and the cooperation of the state insurance commissioners, many of whom had worked for — or would later join — the companies.
The blessing of the rating agencies was relatively easy. Indeed, for years, the standard operating procedure of the leading insurance company rating agency, A.M. Best & Co., was towork closely with the insurers.
If you ran an insurance company and wanted a rating, the deal that Best offered you was very favorable indeed. Best said, in effect: “We give you a rating. If you don’t like it, we won’t publish it. If you like it, you pay us to print up thousands of rating cards and reports that your salespeople can use to sell insurance. It’s a win-win.”
The ratings process was stacked in favor of the companies from start to finish. They were empowered to decide when and if they wanted to be rated. They got a “sneak preview” of their rating before it was revealed to the public. They could appeal the rating if they didn’t like it. And if they still didn’t get a rating they agreed with, they could suppress its publication.
Three newer entrants to the business of rating insurance companies — Moody’s, Standard & Poor’s and Duff & Phelps — offered essentially the same deal.
But instead of earning their money from reprints of ratings reports, they simply charged the insurance companies a fat, flat fee for each rating — anywhere from $20,000 to $40,000 per insurance company subsidiary, per year.
Later, Best decided to change its price structure to match the other three, charging the rated companies similar up-front fees.
Not surprisingly, the rating agencies gave out good grades like candy. At A.M. Best, the grade inflation got so far out of hand that no industry insider would be caught alive buying insurance from a company rated “good” by Best. Nearly everyone (except the customers) knew that Best’s “good” was actually bad.
Despite all this, First Executive CEO Fred Carr was not satisfied with his rating from Best and went to Standard & Poor’s to get an even better rating.
Typically, S&P charged up to $40,000 to rate an insurance company. And just like the deal with Best, if the insurance company didn’t like it, S&P wouldn’t publish it.
But along with junk bond king Michael Milken, Fred Carr cut an even better deal. Milken paid an extra $1 million under the table and, in exchange, got a guaranteed AAA for his junk bonds and for Fred Carr’s insurance company. All this despite a business model that was predicated largely on junk bond investing!
Getting the insurance regulators to cooperate was not quite as easy. In fact, the state insurance commissioners around the country were getting so concerned about the industry’s bulging investments in junk and unrated bonds, they decided to set up a special office in New York — the Securities Valuation Office — to monitor the situation.
What’s a junk bond? The answer, as I’ve explained, was undisputed: Any bond with a rating from S&P or Moody’s of double-B or lower.
But the insurance companies didn’t like that definition. “You can’t do that to us,” they told the insurance commissioners. “If you use that definition, everybody will see how much junk we have.” The commissioners struggled with this request, but amazingly, they obliged. It was like rewriting history to suit the new king.
This went on for several years. Finally, however, after a few of us screamed and hollered about this sham, the insurance commissioners finally realized they simply could not be a party to the junk bond cover-up any longer.
They decided to bite the bullet. They adopted the standard double-B definition, and reclassified over $30 billion in “secure” bonds as junk bonds. It was the beginning of the final act for the junk bond giants.
The New York Times was one of the first to pick up the story. Newspapers all over the country soon followed. That’s when the large life and health insurance companies began to fall like dominoes — Executive Life of California, Executive Life of New York, Fidelity Bankers Life, First Capital Life — each and every one dragged down by large junk bond holdings.
And this was just the prelude to the biggest failure of all — Mutual Benefit Life of New Jersey, which fell under the weight of losses in speculative real estate.
What about guarantees?
That’s the shakiest aspect of all.
Insurance policyholders are given the impression that, in the event of a failure, their state guarantee funds will promptly reimburse them, much like the FDIC does for savers in failed banks.
But the insurance guarantee funds often have no funds; their standard operating procedure is to raise the money after the fact. That works OK when just a few small companies fail. But when the failures are large, where do they get the money? The guarantee system itself fails.
The consequence: After the giant failures of the 1990s, the state insurance commissioners had no choice but to march into the companies’ headquarters, take over their operations, and declare a moratorium on all cash withdrawals by policyholders.
How many people were affected? We checked the records of each failed company: They had exactly 5,950,422 policyholders; and among these, 1.9 million were fixed annuities and other policies with cash value. If you were one of the 1.9 million, your money was frozen. The authorities wouldn’t let you cash out your policy. They wouldn’t even let you borrow on your policy.
What about the legal mandate for the guarantee funds to reimburse policyholders? The authorities put their heads together and came up with a “creative” solution: To avoid invoking the guarantee system, they decided to change the definition of when a failed company fails.
Instead of declaring that the bankrupt companies were bankrupt, they decided to call them “financially impaired,” or “in rehabilitation.” Then, after many months, the authorities created new companies with new reformed annuities yielding far less than the original policies. They gave policyholders two choices. Either …
“Opt in” to the new company and accept a loss of yield for years to come, or …
“Opt out” and accept their share of whatever cash was available, often as little as 50 cents on the dollar.
It was the greatest disaster in the history of insurance!
Back to the Present
If you think Wall Street ratings agencies have learned some lessons from history, think again.
They still charge the companies big fees — for the ratings they issue to those same companies.
They’re still more concerned with protecting the companies (their primary source of revenues) than protecting the public.
Their ratings process is still riddled with egregious conflicts of interest and bias.
Their business model remains largely unchanged.
Next week: Even larger ratings fiascos and how to avoid them.
Good luck and God bless!
Martin
Martin D. Weiss, Ph.D. | Saturday, June 7, 2014 at 7:30 am
With markets calm, the economy steady and interest rates near zero, it’s finally time to take big risks, right?
Wrong!
As Mike Larson explains in the upcoming issue of
Safe Money Report— and as Larry Edelson warns in
his latest video — it’s precisely these kinds of conditions that consistently lead to disaster.
Central banks flood the world with printed money.
Politicians twist the arms of lenders to dish out mortgages to high-risk borrowers.
Investors abandon safe havens and shun defensive strategies.
Consumers overborrow, overspend, exhaust their meager savings, and dive deeply into debt.
Complacency reigns supreme!
This pattern can continue for months. But then, suddenly, the shocks begin to hit like machine-gun fire:
* Prices begin to soar in one particular sector — food, for example. Then, the inflation spreads to gasoline and other commodities … to college tuition and health care … then to wages and nearly all services. Or, alternatively …
* The Fed, seeking to head off an inflationary surge, decides to take a baby step toward sopping up the excess cash in the economy: It raises interest rates. It’s just a tiny move. But in a bubble economy, it’s enough to set off a chain reaction of panicky retreats by investors. Or …
* A small bank goes bust. Next, a medium-size financial institution bites the dust. Soon, the entire nation is enveloped in a bankruptcy crisis of mammoth dimensions.
Sound familiar? It should. Because this is precisely what has happened repeatedly in cycle after cycle since the end of World War II — and with ever-growing intensity.
Each time, the collapse is broader and deeper than the previous. And each time, the Fed steps in with bigger and bigger guns to revive the economy.
For a reality check, go back to the 1960s, for example. Bank lending is still very conservative. So all the Fed has to do is give banks a bit more leeway to make new loans or reduce interest rates a few notches. That’s more than enough to do the trick.
But then fast forward to the early 2000s, and the picture changes dramatically. Even after the Fed cuts interest rates to the lowest level in more than a half century, it still takes many months for the economy to come back.
And look at what’s happened in the most recent cycle:
Even slashing interest rates to nearly ZERO is not enough.
Even holding them near zero for five long years isn’t enough!
In a desperate attempt to revive the economy, the Fed embarks on the greatest and longest money-printing binge of all time.
And the European Central Bank cuts rates BELOW zero (announced on Thursday)!
Yet, despite these herculean efforts, the economy continues to stagnate, with U.S. GDP actuallycontracting in the first quarter.
What never ceases to amaze me, however, is how little our leaders learn from these repeated experiences.
In Washington and in Brussels, they pat themselves on the back for their “great victory” in “saving” the economy … only to let the bubble pop again after they’ve left office and handed the reins to their successors.
And what’s particularly amazing is how, cycle after cycle, investors gleefully fall for the same great deceptions, over and over again:
Deception #1
It’s the conflicts, bias, payola, cover-ups and scams behind most Wall Street ratings assigned to hundreds of thousands of companies, bonds, stocks, and investments of all kinds.
And it’s precisely at times like these — when investor complacency is high — that the deceptions are the most rampant.
Here’s the key: If something is overrated, it is overpriced. It attracts buyers that think it’s a good investment. But as soon as the naked truth is revealed or the inflated rating is deeply downgraded, investors run in panic; and the resulting price declines can deliver wipe-out losses.
As I explained last month, this could be one of the greatest silent killers in your portfolio. And whether you use ratings or not, it’s essential that you fully understand how you can avoid the risks.
My experience with this sorry saga begins in the late 1980s. I had been rating the safety of the nation’s banks for over a decade, when I decided to expand our coverage to life and health insurance companies.
Why? Because A.M. Best, Moody’s, S&P and Duff & Phelps (now part of Fitch) were giving out A’s like candy, even to insurers loaded with junk bonds. I gave them D’s.
My reward: A hoard of lawyers on the payroll at major insurers attacked like a pack of well-trained foxhounds. Hundreds threatened lawsuits. Two actually filed in court.
One insurance company executive told us he’d run us out of business with legal costs. Another said “Weiss had better shut the @!%# up or get a bodyguard.”
The ACLI, the lobbying arm of the largest life and health companies, sent personal letters to the chief editors of The New York Times and The Wall Street Journal, demanding that they stop quoting me in the press.
Then, even while I was testifying before Congress about the dangers in the insurance industry, ACLI representatives sat in the audience behind my back, passing out anti-Weiss “literature.”
The end result: Within weeks, several giant insurance companies went belly-up just as I’d warned, still boasting high ratings from major Wall Street firms.
 |
| Source: GAO. Click here for entire page ; here for entire report |
* Even after Executive Life of New York failed, A.M. Best, the leading insurance rating agency, didn’t downgrade the company until the next day. (Weiss Ratings had given the company a warning-level grade 372 before it failed.)
* Even after Fidelity Bankers, another major insurer failed, A.M. Best waited two days before it issued its downgrade for the company. (Weiss Ratings had given the company a warning-level grade 308 beforeit failed.)
* Even after First Capital — also a giant insurer — went under, Best waited FIVE days before downgrading. (Weiss Ratings had warned 617 days before the failure.)
* With Monarch, another huge life insurance company, the GAO reports an even sadder story: S&P didn’t downgrade the company to a warning level until 351 days after it failed. Worse, A.M. Best NEVER publicly recognized Monarch’s failure. Instead, four days after the failure, Best changed its “A” rating for Monarch to a non-published category, effectively slipping out the back door by taking the rating out of circulation. (Weiss Ratings had given the company a warning-level rating 162 days before the failure.)
* And with Mutual Benefit, the story is downright tragic. It was the biggest failure of all, with the largest number of victims and the biggest losses — mostly in speculative real estate. Yet, Moody’s didn’t downgrade until two days after the failure; Best didn’t act until three days after; and S&P never downgraded the company.
The GAO study proved that the only rating agency that predicted all of these failures — and the only one that correctly identified the truly safe companies — was Weiss Ratings. (For the evidence, go
here.)
Deception #2
So far, I’ve been talking strictly about insurance company ratings.
But the business of rating common stocks is similar in one critical way: Ratings are often inflated, especially in calm and complacent times like these.
What’s most shocking, however, is how common it has been for Wall Street analysts to continue to lavish praise on a particular stock, even after the company is on the verge of bankruptcy.
To better quantify this shocking trend, my team and I went back to 2002, and we conducted a study on 19 companies that (a) filed for Chapter 11 bankruptcy in the first four months of that year and that (b) were rated by major Wall Street firms.
The result: Among these 19 companies, 12 received a “buy” or “hold” rating from all of the Wall Street firms that rated them.
Furthermore, they continued to receive those unanimously positive ratings right up to the day they filed for bankruptcy.
Thus, even diligent investors who sought second or third opinions on these companies would have run into a stone wall of unanimous “don’t-sell” advice.
Further, we found that, among the 47 Wall Street firms that rated these stocks, virtually all were guilty of the same shenanigans. The Wall Street firms led them like lemmings to the sea, with rarely one dissenting voice in the crowd.
For investors, and for the market as a whole, the consequences were catastrophic …
In April 1999, for example, Morgan Stanley Dean Witter stock analyst Mary Meeker — dubbed “Queen of the Internet” by Barron’s — issued a “buy” rating on Priceline.com at $104 per share. Within 21 months, the stock was toast — selling for $1.50.
Investors who heeded Ms. Meeker’s recommendation would have lost 98 percent of their money, turning a $10,000 mountain of cash into a $144 molehill.
Undaunted, Ms. Meeker also issued “buy” ratings on Yahoo, Amazon.com, Drugstore.com, and Homestore.com. The financial media reported the recommendations with a straight face. Then, Yahoo crashed 97 percent; Amazon.com 95 percent; Drugstore.com 99 percent; and Homestore.com 95.5 percent.
Why did Ms. Meeker recommend those dogs in the first place? And why did Ms. Meeker stubbornly stand by her “buy” ratings even as they crashed 20, 50, 70 percent, and, finally, as much as 99 percent?
One reason was because virtually every one of Ms. Meeker’s “strong buys” was paying Ms. Meeker’s employer — Morgan Stanley Dean Witter — to promote its shares, and because Morgan Stanley rewarded Ms. Meeker for the effort with a $15 million paycheck.
While millions of investors lost their shirts, Morgan Stanley Dean Witter and Mary Meeker, as well as the companies they were promoting, cried all the way to the bank.
An isolated case? Not even close! In 1999, Salomon Smith Barney’s top executives received electrifying news: AT&T was planning to take its giant wireless division public, in what would be the largest Initial Public Offering (IPO) in history.
Naturally, every brokerage firm on Wall Street wanted to do the underwriting for this once-in-a-lifetime IPO, and for good reason: The fees would amount to millions of dollars. But Salomon had an issue. One of its chief stock analysts, Jack Grubman, had been saying negative things about AT&T for years.
A major problem? Not really. By the time Salomon’s hotshots made their pitch to pick up AT&T’s underwriting business, Grubman had miraculously changed his rating to a “buy.”
More examples:
- Mark Kastan of Credit Suisse First Boston liked Winstar almost as much as Grubman did, issuing and reiterating “buy” ratings until the bitter end. No surprise there: Kastan’s firm owned $511 million in Winstar stock.
- In 2000, an analyst at Goldman Sachs oozed 11 gloriously positive ratings on stocks that subsequently smashed investors’ portfolios. He got paid $20 million for his efforts. One of his best performing recommendations of the year was down 71 percent; his worst was down 99.8 percent.
- Merrill Lynch’s Henry Blodget gained fame by predicting Amazon.com would hit $400 per share. It was soon selling for under $11. Blodget also predicted that Quokka Sports would hit $1,250 a share. It went bankrupt. He issued and reissued strong “buy” ratings for Pets.com (went out of business), eToys (lost 95 percent of its value), InfoSpace (shed 92 percent), and Barnes & Nobel.com (lost 84 percent of its value). Yet even while investors lost billions, Merrill Lynch cleaned up — $100 million on Internet IPOs alone.
In each of these cases, brokerages made millions. The analysts made millions. The companies they promoted raked in millions. But investors lost their shirts.
Not one major firm on Wall Street tied its analysts’ compensation to their actual track record in picking stocks. Analysts could be wrong once, wrong twice, wrong a hundred times, and they’dstill earn huge bonuses, as long as they continued to recommend the shares and as long as there were still enough investors who continued to buy into the hype. That’s how the investment banking divisions wanted it, and that’s how it stayed.
What if it was abundantly obvious that a company was going down the tubes? What if an analyst personally turned sour on the company?
Would that make a difference? Not really.
For the once-superhot Internet stock Infospace, Merrill’s official advice was “buy.” Privately, however, in e-mails uncovered in a subsequent investigation, Merrill’s insiders had a very different opinion, writing that Infospace was a “piece of junk.”
Result: Investors who trusted Merrill analysts to give them their honest opinion got clobbered, losing up to 93.5 percent of their money when Infospace crashed.
Merrill’s official advice on another hot stock, Excite@Home, was “accumulate!” Privately, however, Merrill analysts wrote in e-mails that Excite@Home was a “piece of crap.” Result: Investors who trusted Merrill lost up to 99.9 percent of their money when the company went under.
For 24/7 Media, “accumulate!” was also the official Merrill Lynch advice. Merrill’s internal comments were that “24/7 Media is a “piece of s–t.” Result: Investors who relied on Merrill’s advice lost 97.6 percent of their money when 24/7 Media crashed.
Has the payola and bias on Wall Street ended?
Suffice it to say, it comes in waves — in cycles. And as I warned at the outset, the current cycle of complacency does not favor investor vigilance — let alone Wall Street transparency.
Quite to the contrary, it’s the perfect climate for more scams and deceptions.
Don’t get caught. Be sure to invest instead in the best of the best, especially companies that merit a top Weiss Rating.
Good luck and God bless!
Martin
