Friday, October 21, 2011

End CRAPitalism!

Yes, I intentionally misspelled the title of this post.  And, no, I am not a socialist, but as a capitalist I see three horrific conflicts of interest within the current configuration of our capital markets that makes them almost un-investable.  All three conflicts of interest stem from who pays our most important watch dogs.

Bond Ratings Agencies
First, investors in bonds rely on bond ratings (i.e. AAA, AA, A, BBB, etc.) issued by "ratings agencies" such as S&P, Moody's, and Fitch.  These ratings are supposed to be based on objective, detailed analysis.  But such analysis is time consuming and thus expensive.  Who gets to choose whom to hire among S&P, Moody's, and Fitch?  You guessed it - company management hires the ratings agency.  Who pays the chosen ratings agency?   The company pays the ratings agency!

The fox does not guard the hen house, but the fox hires the watchdog!

Stock Analysts
Second, investors in stocks rely on stock ratings (Buy, Hold, Sell) issued by Wall Street analysts.  These supposedly independent stock analyses almost never result in a "Sell" rating.  Why?  A Wall Street analyst that issues a "Buy" rating is a CEO's best ally.  The CEO and other executive management have stock options and want the stock to rise. And, the CEO will pick which investment banking firm will earn fat merger and acquisition advisory fees.  Thus, a stock analyst won't want to risk issuing a "Sell" rating when it could jeopardize his firm's chances of earning fat investment banking fees.

The investment banking industry will point to SEC regulations that require a "Chinese Wall" inside investment banks that separates the stock rating division from the merger and acquisition advisory division.  The "Chinese Wall" is primarily in place to prevent the merger and acquisition advisory division from sharing non-public information with the stock rating division.  Even the most foolish stock analyst certainly realizes a "Sell" rating could hurt his firm's chances of winning fat investment banking fees even without penetrating the so-called "Chinese Wall."  After all, the stock analyst likely owns stock options in his own firm and thus wants all the divisions of his firm to do well.

Since investors cannot rely on the compromised opinions on either stocks or bonds, investors need to do their own analysis of company financial statements.  That brings us to problem number three.

Third, investors in stocks and bonds of corporations rely on "audited" annual financial statements.  The financial statements are prepared by "management," but supposedly under the watchful eye of an external auditor that assures us that the financial statements "fairly represent" the true financial status of the company.

The problem? Who do you think hires the auditor? You guessed it - company management hires the auditor.  Who pays the auditor? The company pays the auditor.  This might not quite be the fox guarding the hen house, but the fox definitely hand picks and pays the watchdog!

In the past, I've worked within the corporate finance department of a huge, Fortune 100 company with stock that traded on the New York Stock Exchange.  I personally attended meetings between management and our external auditor to discuss and debate certain assumptions affecting our financial statements.  The external auditor lost every debate.

Problem Summary
Bond rating agencies, stock analysts, and auditors are all directly or indirectly compensated by the companies they monitor. Investors beware.

Possible Solutions
Bond ratings agencies actually double-dip. Ratings agencies earn fees from the entities they rate, but also sell their ratings to investors.  The solution is simple, bond rating agencies should not be allowed to earn fees from the entities they rate. Rating agencies should only be allowed to sell their ratings to investors that rely on their opinion.  Ratings agencies surely would claim they can't survive without the fees they charge the firms they rate.  However, I believe the ratings agencies would eventually make up this difference as investors would be willing to pay more for their ratings once the ratings agencies conflict of interest is eliminated. Right now, their bond ratings are worthless.

Investment banking firms should not be allowed to both rate stocks and earn fees from the companies they rate.  Investment banks, many that are also too big to fail, should be split right down that so-called "Chinese Wall."  The stock rating divisions should be spun off into separate companies.  Like the bond ratings agencies, I believe investors would eventually be willing to pay more for the stock ratings once the stock ratings firms conflict of interest is eliminated. Right now, their stock ratings are worthless.

Solving the conflict of interest with the auditing firms is a more complicated problem.  All investors, ratings agencies, and stock analysts rely on the financial statements issued by firms.  In a perfect world, the folks that rely on the financial statements should hire, fire, and pay the auditors.

Perhaps the stock exchanges should be saddled with picking and paying the auditor for the companies whose stock trades on their exchanges?  The stock exchanges could raise their listing fees to pay for this new burden.  Or, perhaps the Securities and Exchange Commission (SEC) should levy a fee on companies and in turn hire and fire the auditor?

Capitalism has become cRapitalism since investors have no where to go for reliable information.  None of my proposed solutions are perfect, but I think they are better than the current systems we have now.  I believe my solutions above, combined with the outlawing of executive stock options, can save and improve capitalism.

1 comment:

  1. I should more accurately point out that a firm's Board of Directors makes the final decision on which auditor to hire. Although, many boards merely rubber-stamp recommendations of management. Quite often CEOs are members of the board as are other company executives.