Last week, MSCI, Inc., a provider of investment support tools, agreed to acquire RiskMetrics Group Inc., the leading provider of risk management services, corporate governance ratings and proxy advisory services, in a deal valued at approximately $1.55 billion. While markets and analysts responded positively to the news, this exuberance may be short-lived thanks to RiskMetrics' wholly-owned subsidiary, ISS. ISS is incompetent and it is only a matter of time before markets and regulators realize.
ISS or Institutional Shareholder Services is a ticking time bomb waiting to explode. ISS sells proxy voting advice services to institutional investors, issues corporate governance ratings on publicly traded companies, and operates with minimal accountability and transparency. A significant portion of institutional investors, including some 80% of mutual funds and 68% of pension funds, rely on ISS' advice and corporate governance ratings, but the MSCI deal and the recent financial crisis call into serious doubt whether investors should be following ISS' judgment in the first place.
Exactly fourteen days before Lehman Brothers Holding, Inc. filed for bankruptcy in September 2008, ISS gave Lehman a corporate governance rating of 87.6%, meaning that Lehman's corporate governance in ISS' view was better than 87.6% of other diversified financial companies. ISS also doled out generous ratings to other ailing financial companies such as Washington Mutual, which was rated by ISS as being "better than 44.3% of S&P 500 companies and 95.6% of [b]ank companies" just weeks before it's undoing. And if that was not enough, a few days before AIG scurried to put together an emergency loan, ISS rated AIG as being "better than 97.9% of S&P 500 companies and 99.2% of [i]nsurance companies."
ISS defends its corporate governance ratings (known as the "CGQ") as a "dynamic corporate governance tool that helps investors manage investment risk and drive value" and ISS touts its CGQ as a tool that helps investors "identify the worst corporate offenders." Well, if this is true, several questions come to mind. First, why did the CGQ fail the market in this last financial crisis? Second, in light of the obvious fallacies in ISS' CGQ, should investors place any stock in them as a reliable measure of a company's corporate governance? And third, if the CGQ does indeed help investors identify the "worst corporate offenders", why did RiskMetrics, ISS' parent, agree to be bought by MSCI, who according to ISS has a CGQ of 2.5%? This means that in ISS'/RiskMetrics' view, MSCI is in the bottom 2.5% of all S&P 400 companies in terms of corporate governance, or to use their own words, MSCI is one of the "worst corporate offenders." By agreeing to take MSCI stock as consideration for the merger, RiskMetrics' action belies the reliability of its own corporate governance ratings system.
The evidence is clear -- there is serious reason to doubt ISS' ratings and investors would do well to stop relying on ISS' view of corporate governance.
Moreover, ISS has also been repeatedly criticized for being riddled with conflict of interest problems, using faulty analysis in coming up with its voting recommendations, making errors, mistakes and/or omissions that impact its proxy voting advice, hiring relatively unskilled employees to conduct its analysis, being "blatantly opportunistic" in peddling its services, and merely following the fad of the time instead of truly developing well-thought out, sound corporate governance policies. In fact in 2003, ISS acknowledged that sometimes its advice was less than stellar, and with regard to a particular incident acknowledged that it had "screwed up...[and] was embarrassed by the [revealed] operational misstep." Of course while after-the-fact apologies may serve some therapeutic purpose, the problem is that when mutual funds and other institutional investors follow ISS' recommendations en masse and those recommendations turn out to be faulty, it is not ISS that is left holding the bag. Instead it is the underlying portfolio companies affected by the recommendations and the long-term shareholders of those companies.
Thus for MSCI, while the RiskMetrics acquisition promises to result in significant cost synergies, the deal also promises to expose MSCI's corporate structure to substantial risk unless they can figure out what to do with ISS. ISS' ratings and advice are unreliable and it is only a matter of time before investors lose confidence.
Ironically, the success of MSCI's acquisition hinges on the bet that once again ISS has miscalled it, and that contrary to ISS' ratings, the management of MSCI actually knows what it is doing.
What AIG owes, and what it plans to pay back with two deals it says will bring in $51 billion.
Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Failure to act now will only mean the U.S. will be forced to act after these "financial weapons of mass destruction" levy heavy casualties. These obligations now settle in euros, but the end game is to settle them in gold. This is so ripe for speculative manipulation that you might as well cover the U.S. map with a bull's-eye.
Credit default swaps are not insurance. If you buy fire insurance on your home, you must own the house. If you buy credit protection on the United States, however, you do not need to own U.S. Treasury bonds. If your protection gains value after you buy it -- not because the U.S. defaults, but because of market mood changes -- you can resell that protection and make a profit.
Lower credit risk means a lower price for protection. Zero implies zero risk. The higher the basis points, the higher the implied risk. When U.S. credit default swaps were first introduced, the price of protection was around two basis points. According to Bloomberg, the price for five-year protection was around 38 basis points on Friday. But the price in the over-the-counter market -- where this stuff actually trades -- was almost double or around 75 basis points.
Since most traders in U.S. credit default swaps don't think the U.S. will default any time soon, why are they trading U.S. credit default swaps? They are speculating on price movements the way a day trader buys and sells stocks to speculate on stock price movements.
Volume in U.S. credit default swaps is relatively small, but it can explode rapidly, just as volume expanded rapidly for credit default swaps on mortgage debt in 2006 and 2007.
Speculators Want U.S. CDS Payoffs in Gold
Remember AIG? When prices moved against AIG on its credit default swap contracts, AIG owed cash (collateral) to its trading partners. AIG paid billions of dollars and owed billions more when U.S. taxpayers bailed it out in September 2008.
U.S. credit default swaps currently trade in euros. After all, if the U.S. defaults, who will want payment in devalued U.S. dollars? The euro recently weakened relative to the dollar, and market participants are calling for contracts that require payment in gold. If they get their way, speculators on the winning side of a price move will demand collateral paid in gold.
The market can create an unlimited number of these contracts very rapidly. The U.S. wouldn't have to ever default to trigger a major disruption in the gold market. Spreads (or prices) on the credit default swaps could simply move based on "news," and demand for gold would soar.
If this speculation drives up the price of gold, and the available gold supply becomes limited, are you willing to post your children as collateral? I am pushing the point so that we put a stop to this before it is too late.
Global Disaster in the Making
More than a year has passed since former Treasury Secretary Henry Paulson went to Congress in September 2008 to plead for special powers and TARP money to bail out U.S. financial institutions. Yet there has been no meaningful financial reform.*
The European Union has its own challenges. German Chancellor Angela Merkel recently called for limits on credit derivatives on Greece, since the European Union is concerned about misuse of credit derivatives for speculation. Chancellor Merkel did not go far enough.
World leaders shouldn't merely ask for limits on sovereign credit derivatives. They should demand a ban on all sovereign credit default swaps.
*This video explains how cheap money, wide-spread bad (often predatory) lending, phony securities, credit derivatives, and Wall Street banks' massive over-borrowing led to our current financial crisis. Yet there is still no meaningful reform. Explanation of credit derivatives begins at 8:00.
Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Failure to act now will only mean the U.S. will be forced to act after these "financial weapons of mass destruction" levy heavy casualties. These obligations now settle in euros, but the end game is to settle them in gold. This is so ripe for speculative manipulation that you might as well cover the U.S. map with a bull's-eye.
Credit default swaps are not insurance. If you buy fire insurance on your home, you must own the house. If you buy credit protection on the United States, however, you do not need to own U.S. Treasury bonds. If your protection gains value after you buy it -- not because the U.S. defaults, but because of market mood changes -- you can resell that protection and make a profit.
Lower credit risk means a lower price for protection. Zero implies zero risk. The higher the basis points, the higher the implied risk. When U.S. credit default swaps were first introduced, the price of protection was around two basis points. According to Bloomberg, the price for five-year protection was around 38 basis points on Friday. But the price in the over-the-counter market -- where this stuff actually trades -- was almost double or around 75 basis points.
Since most traders in U.S. credit default swaps don't think the U.S. will default any time soon, why are they trading U.S. credit default swaps? They are speculating on price movements the way a day trader buys and sells stocks to speculate on stock price movements.
Volume in U.S. credit default swaps is relatively small, but it can explode rapidly, just as volume expanded rapidly for credit default swaps on mortgage debt in 2006 and 2007.
Speculators Want U.S. CDS Payoffs in Gold
Remember AIG? When prices moved against AIG on its credit default swap contracts, AIG owed cash (collateral) to its trading partners. AIG paid billions of dollars and owed billions more when U.S. taxpayers bailed it out in September 2008.
U.S. credit default swaps currently trade in euros. After all, if the U.S. defaults, who will want payment in devalued U.S. dollars? The euro recently weakened relative to the dollar, and market participants are calling for contracts that require payment in gold. If they get their way, speculators on the winning side of a price move will demand collateral paid in gold.
The market can create an unlimited number of these contracts very rapidly. The U.S. wouldn't have to ever default to trigger a major disruption in the gold market. Spreads (or prices) on the credit default swaps could simply move based on "news," and demand for gold would soar.
If this speculation drives up the price of gold, and the available gold supply becomes limited, are you willing to post your children as collateral? I am pushing the point so that we put a stop to this before it is too late.
Global Disaster in the Making
More than a year has passed since former Treasury Secretary Henry Paulson went to Congress in September 2008 to plead for special powers and TARP money to bail out U.S. financial institutions. Yet there has been no meaningful financial reform.*
The European Union has its own challenges. German Chancellor Angela Merkel recently called for limits on credit derivatives on Greece, since the European Union is concerned about misuse of credit derivatives for speculation. Chancellor Merkel did not go far enough.
World leaders shouldn't merely ask for limits on sovereign credit derivatives. They should demand a ban on all sovereign credit default swaps.
*This video explains how cheap money, wide-spread bad (often predatory) lending, phony securities, credit derivatives, and Wall Street banks' massive over-borrowing led to our current financial crisis. Yet there is still no meaningful reform. Explanation of credit derivatives begins at 8:00.
