Tuesday, October 6, 2009

Enough Scapegoats: Where Were The Rating Agencies?

In just one week, the trial will begin for two former Bear Stearns hedge fund managers- Ralph Cioffi and Mathew Tannin accused of fraud. However, yesterday, U.S. District Judge Fredric Block denied prosecutors’ request to allow jurors specific information regarding the managers personal spending habits.

“No, I’m not going to allow it,” Block said. “They will know this person made $20 million a year.”

The prosecutors had hoped to introduce the exact membership fee's of the country clubs the manager belonged to as well as Ralph Cioffi's three exotic Ferrari's. Their intent is to persuade the jury that the manager spent significant sums of money on an expensive lifestyle which would have ended once the sub-prime markets crashed and in order to perpetuate this lifestyle, Mr. Cioffi & Mr. Tannin intentionally misled their clients about the health of the sub-prime market.

Cioffi and Tannin are accused of misleading investors in the two hedge funds, the Bear Stearns High-Grade Structured Credit fund and more highly-levered sister fund, about the health of the funds just prior to their collapse, which cost investors $1.6 billion. Cioffi also faces an insider-trading charge. The failure of the two hedge funds, in July 2007, helped precipitate the collapse of Bear Stearns less than a year later, in March 2008.

But many believe that these men and the case itself are being used as scapegoats by regulators and prosecutors both of whom are under tremendous pressure to provide the public with individuals to hold accountable for a systemic collapse. Trillions of dollars have been lost world wide, some of the worlds largest insurance companies, banks, auto makers and financial services titans have been bankrupted. It's glaringly obvious that these men cannot possibly be personally accountable for an international economic crisis.

At the center of the prosecutions case is an email from Tannin, the funds CFO to his friend Ray McGarrigal. According to prosecutors, in an April 22, 2007 e-mail, Tannin lamented the state of his hedge funds, which were heavily invested in subprime mortgage securities.

“The entire sub-prime market is toast,” Tannin wrote. “There is simply no way for us to make money—ever.” A few days later, according to prosecutors, he was lauding the both his funds and the subprime market during a conference call with investors. he commented, that in fact he was, “very comfortable with exactly where we are,” and of regarding the subprime problems, “there’s no basis for thinking this is one big disaster.”

It was an extremely poor choice of words Tannin chose to lament to his friend, but in the end, this is just one friend complaining to another about his dead end job. Imagine their surprise when only a few days later, incompetent regulators befriended by over-zealous prosecutors scouting high and low for scapegoats to sacrifice to the angry, poor huddled masses, gathered a grand jury and turned Tannin's e-mail gripe session with a former colleague, into a massive scenario of fraud.

That's how easily it happens. On Monday, you're a frustrated fund manager complaining about business (perhaps to vehemently) to a colleague. On Tuesday, you do your best to adjust your attitude realizing as always, your fiduciary responsibilities come first. On Wednesday on a conference call you do your best to keep investors calm during an unforeseen and as of yet undefined crisis. Thursday, you are doing your best to gather information on the crisis and on Friday, you've been indicted for committing fraud while becoming the worlds poster-child for the collapse of Bear Stearns.

Perhaps it is time we took a step back and remember before this is all behind us and it's too late, the rating agencies are all clearly at fault. They all failed miserably at their jobs. In fact, failing miserably at their jobs may not be a strong enough term as implies that they did their jobs at all. S&P, Moody's and their cohorts are directly responsible for this crisis. Investors and managers both utilize the ratings agencies in order to gauge the value of their investments. The agencies ratings were wrong which led to investor confusion and over-valuation, which led to the ratings cuts that were deemed too little, too late. the rating agencies couldnt have blundered more if they had tried. This is a fact and is undisputed, yet there have been no arrests, no indictments and it is business as usual for the agencies.

Cioffi and Tannin, like most of those investigated in the aftermath of the credit crisis, are simply scapegoats. Low dangling fruit. Easy to pick and easy to point to. Instead of scapegoats, we should be investigating and then initiating a complete overhaul of the ratings industry. Ratings agencies need to be far more highly scrutinized and in all likely hood far more regulated. We need to weed out those responsible for the financial collapse and replace them with new analysts and new agencies. We must rebuild the portion of the system that failed. Nobody is more responsible and nobody failed more than the rating agencies.

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