SEC gets tough, but only with little guys

Moody's executive Jerome Fons, Standard and Poor's executive Frank Raiter, and Egan-Jones Ratings Managing Director Sean Egan, take the oath on Capitol Hill. The SEC has targeted Egan, not the two agencies with global clout.
Moody's executive Jerome Fons, Standard and Poor's executive Frank Raiter, and Egan-Jones Ratings Managing Director Sean Egan, take the oath on Capitol Hill. The SEC has targeted Egan, not the two agencies with global clout. Lawrence Jackson/AP Photo

The Securities and Exchange Commission seems to think that it has done a much better job of investigating financial crisis wrongdoing than the Justice Department. And it's true.

But it's like being proud that you're the "Dumb" of "Dumb and Dumber."

A case the commission filed last week epitomizes a lot of what's wrong with the agency, even under the supposed overhaul by its chairwoman, Mary L. Schapiro.

The agency brought a civil case against a tiny, iconoclastic ratings agency called Egan-Jones, run by the outspoken Sean Egan, accusing it, essentially, of filling out forms wrong.

Before the SEC charges, Egan-Jones was best known for two things: having made some bold calls about shaky credit prospects and having a business model that was different from that of the big boys - Moody's Investors Service, Standard & Poor's and Fitch. Egan's outfit gets paid by the users of his ratings; the oligopoly gets paid by the issuers whose debt is going to be rated.

You don't need to be a hedge fund quant to see the conflict of interest: the more ratings, the more profits to the ratings agencies, so the temptation is to be extra lenient. And, boy, were they.

Egan wasn't shy about pointing this out, often through media appearances. To be honest, one wondered how much was showmanship and how much was deep research.

But the world needs his brand of punditry, especially on Wall Street, where the uncorrupted are too afraid to speak out. Egan has been prescient on some important calls about declining credit prospects, ahead of both the European financial crisis and the American mortgage and structured finance bubble before that.

The SEC's case against Egan and his firm concerns a filing made in 2008 seeking special designation to be a "nationally recognized statistical ratings organization." This status confers some rights and special privileges under securities laws, and it's one of the main competitive advantages the credit ratings trinity has.

The agency makes a variety of allegations. For one, Egan-Jones represented in its application that it had 150 ratings on asset-backed securities and 50 ratings on governments, when it hadn't issued any at the time, the SEC says. To the guillotine! (Egan-Jones responds that it was using a different counting method.)

Some allegations are more serious, but only slightly. The agency contends that two Egan-Jones employees had a role in rating issuers while owning securities in those issuers. The firm says these employees had long-standing investments and that it actually brought these violations to the attention of the SEC.

All told, the allegations seem especially paltry when compared with the disastrous performance of the ratings agencies that matter - Moody's and S&P. Egan-Jones' ratings didn't cripple the global economy. Egan's business model is far less prone to compromise and corruption. The inescapable conclusion is that the SEC is letting Moody's and S&P officials walk free while pursuing Egan on minor technicalities.

This is your SEC, folks. It courageously assails tiny firms, and at the pace of a three-toed sloth. And when it goes after its prey, it's because it has found a box unchecked, rather than any kind of deep, systemic rot.

Unfortunately, there's an even worse problem here. The action against Egan gives the appearance, perhaps inadvertently, that the agency is persecuting a longstanding critic of the ratings agencies. That just solidifies the woeful ratings oligopoly we have today.

Now, the SEC doesn't see it this way, naturally. The agency says that bringing one case doesn't preclude another. And it's true that there have been news reports of investigations into the ratings firms regarding actions that led to the financial crisis, including notices that it plans to bring charges over some ratings.

John Nester, a commission spokesman, said the agency stood up to the big boys.

"Our record shows beyond dispute that no institution is immune from SEC charges when we find violations of the securities laws," he said, pointing to, among others, Goldman Sachs, Citigroup, JPMorgan Chase and Bank of America.

Relative to Eric Holder's Justice Department, that record makes the SEC look like the god Shiva, destroyer of worlds. But the SEC has hardly been aggressive about the ratings agencies. It hasn't moved against any top executives of any major ratings firm for actions leading to the financial crisis.

In one of its timorous moments, the agency punted on a case involving Moody's and a questionable rating on a complicated European structured finance product. The SEC determined that it was unclear whether it had jurisdiction because the securities were created and sold in Europe.

Promising leads on other potential wrongdoing by credit rating agencies seemingly go to the SEC to die. A whistle-blower - Eric Kolchinsky, a former Moody's executive who oversaw the firm's collateralized debt obligation ratings - claimed that Moody's inflated ratings on a loan deal called Nine Grade Funding in January 2008 because it had already made a decision that it was going to downgrade the assets that were going into the deal.

Some three years after that allegation was dropped at the door of the SEC, there's been no action so far on the deal.

Moody's declined to comment. The SEC does not confirm or deny investigations. Given that the regulator's bark is worse than its bite, Egan-Jones will probably be able to wriggle out of the agency's clutches with a settlement and a fine. Egan's business will be damaged, but he is likely to still have one.

The help that the SEC has given the oligopoly will last, however. Any small company looking at filing for special status will think twice. While they ponder, Moody's, S&P and Fitch will continue to earn fat profits, and their executives walk free.

Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest.

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