You put a big chunk of your nest egg in a life insurance policy with an A+ company.
You invest another sizable amount in a portfolio of high-rated corporate bonds and tax-free municipal bonds.
Then, feeling safe and secure with most of your funds, you take a flyer on a few stocks that a half-dozen separate research analysts have unanimously rated as a "buy" or at least a "hold."
You assume you've made informed decisions based on the best research the world has to offer.
The reality: Even in the absence of bubbles or busts, you could suffer wipeout losses.
Hard to believe this could actually happen? Actually, it already has happened. And one of my paramount goals in my Ultimate Portfolio is to make absolutely certain you don't get caught in Wall Street deceptions like these in the future. So in this article, I tell you what they are, how they emerged, and how to avoid them.
Their primary cause: Legalized payola and massive conflicts of interest.
The primary result: Distorted research and inflated ratings on hundreds of thousands of companies, bonds, stocks, and investments of all kinds.
The threat to you: Far fewer profits (or bigger losses) in your investments than you would have anticipated otherwise.
Take the Right Steps NOW!
I'm so concerned about the massive new threats to your income, savings, investments and retirement detailed in this report ... And I'm so confident that simply by taking the right steps now, you can USE these fast-breaking events to multiply your money ... I am ready, willing and able to give you everything you need to help protect and multiply your wealth in 2015 — absolutely FREE!
Click here to view now! -Larry
Indeed, Wall Street's inflated ratings are, themselves, a kind of bubble, which, when fully exposed, could suffer a great bust of its own — deepening the price decline, hurting the chances of each company's survival, and aggravating any economic crisis.
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 severely compromised, it places everyone in danger, whether an investor or not, whether rich or poor.
My experience with this sorry saga begins in the late 1980s.
I had been rating the financial strength of the nation's banks and S&Ls for over a decade, and by this time, Dad was already an octogenarian.
One afternoon I told him that Weiss Ratings was going to start rating insurance companies. I can never forget his first words: "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, and we found quite a few life insurance companies that were loaded with junk bonds, one of which was First Capital Life, to which we gave a financial strength rating of D-. 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 you are?"
I politely explained that we never let personal threats affect my ratings. And unlike other rating agencies, Weiss Ratings never accepts a dime from the companies we rate. "We 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." That's when one of them delivered the ultimate threat: "Weiss better shut the @!%# up," he whispered to my associate, "or get a bodyguard."
We did neither. To the contrary, we intensified our warnings. And within weeks, the company went belly-up, just as Weiss Ratings had warned — still boasting high ratings from major Wall Street firms on the very day they failed. In fact, the leading insurance rating agency, A. M. Best, didn't downgrade First Capital Life to a warning level until five 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%, 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 the Weiss 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 the Weiss 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 — Standard & Poor's (S&P), Moody's, A. M. Best, Duff & Phelps, and Weiss — to testify. But we were the only ones among them who showed up. So Congress asked its auditing arm, the U.S. Government Accountability Office (GAO), to conduct a detailed study on the Weiss ratings in comparison to the ratings of the other major rating agencies.
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 issuers of bonds, insurance policies and other investments that you buy. In other words, their ratings are literally bought and paid for by the same companies they rate.
Ratings Fiasco 1
How Deceptive Ratings Entrapped Two Million Americans in Failed Insurance — and Why It Could Happen to You!
These conflicts and bias in the ratings business are no trivial matter. Consider carefully three of the ratings fiascos of recent times and you'll see what I mean.
If you have insurance, don't blindly assume it's safe. In a moment, I'll show you how two million others once made that mistake and lived to regret it. And to help you avoid repeating their error, it's vital that you understand their story from start to finish.
The problems began in the early 1980s when insurance companies had guaranteed to pay high yields to investors of 10% or more, but the best they could earn on safe bonds was 8, 7, or 6%. 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, like the U.S. government or a financially robust corporation, 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 less secure borrower — maybe a start-up company or perhaps a company that's had some ups and downs in recent years. And you can earn even more interest from companies that have been having "a bit of trouble" paying their bills lately. (Whether you'll actually be able to collect that interest or get back your principal is another matter entirely.)
What's secure and what's risky? In the corporate bond world, everyone agreed to use the standard rating scales originally established by the two leading bond rating agencies — Moody's and S&P. 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; and so on.
If a bond is triple-B or better, it's investment grade. That's considered relatively secure. If the bond is double-B or lower, it's speculative grade, or simply "junk." It's not garbage you'd necessarily throw into the trashcan, but in the parlance of Wall Street, it's officially known as junk. And that's what insurance companies started to buy: 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. These companies weren't just reluctantly forced to buy junk bonds to fulfill old promises. 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. 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 — those same insurance 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 to "work 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 take it out of circulation by suppressing its publication.
Three newer entrants to the business of rating insurance companies — Moody's, S&P, and Duff & Phelps (not Fitch) — 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 $10,000 to $50,000 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 dead buying insurance from a company rated "good" by Best. Nearly everyone (except the customers) knew that Best's "good" was actually bad.
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 giant junk bond insurance companies.
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 Federal Deposit Insurance Corporation (FDIC) does for savers in failed banks. But the insurance guarantee funds have no funds; their standard operating procedure is to raise the money after the fact. That works okay 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? I checked the records of each failed company: In total, 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 in failed companies? The authorities put their heads together and came up with a "creative" solution: To avoid invoking the guarantee system, they simply 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:
1. "Opt in" to the new company and accept a loss of yield for years to come, or ...
2. "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!
So you'd think that the insurance industry would have learned its lessons. Not so! To this day, the companies are still rated by the same rating agencies, in the same way with the same conflicts of interest.
Like the failed insurers of the 1990s, several large U.S. insurance companies, on the prowl for high yields, invested again in high-risk instruments. Junk bonds were still stigmatized, but a handy substitute for junk was readily available: subprime mortgages. And to make things even more exciting, some insurers added a whole new layer of risk: a special kind of bet known as a credit default swap (CDS) — a bet placed on the probability of another company's failure.
Remember, in the prior episode, the rating agencies collected large fees from the companies for each grade. That, in turn, introduced serious conflicts of interest into the process and often biased the ratings in favor of the companies. This time around, they did precisely the same thing: They collected the same kind of big fees. They gave out the same kind of top-notch ratings. And they covered up the same kind of massive risks.
In addition, S&P, Moody's, and Fitch created a whole new layer of conflicts and bias: They hired themselves out as consultants to help create newfangled debt-backed securities, giving them a true lock on the industry: they created the securities. They rated the securities. And then they rated the companies that bought the securities, collecting fat fees at each stage of the process.
Not only did that pad the bottom line of the rating agencies, it also gave them stronger reasons to inflate the ratings, ignore warning signs, postpone downgrades, and avoid anything that might bring down the debt pyramid they had helped to create.
The repercussions of this disaster were multiple, and as a part of the Regulatory Reform Act of 2010, Congress sought to address them. But the fundamental business model of the established rating agencies was not changed. They continued to collect large fees from issuers for giving them ratings. And the obvious conflict of interest that naturally flows from that financial relationship continued to persist, leaving the danger of more ratings fiascos to come.
Ratings Fiasco 2
How Wall Street's "Research" Duped Millions of Investors
If you think insurance customers got a bad deal in the early 1990s, wait till you see what happened to investors in the early 2000s! And if you think these deceptions are a thing of the past, wait till you see what happened in the 2008 debt crisis and could happen again in the next great recession.
To be sure, the business of rating stocks is different from the business of rating insurance companies. Instead of just four firms, we counted 47 Wall Street investment banks and brokerage firms that published research and ratings on stocks.
The rating scales were also different and varied. But in essence, they all boiled down to recommendations to "buy," "sell," or "hold."
Unlike the bond and credit ratings, there was ostensibly no charge to the companies for the ratings. But, for reasons that soon became evident, nearly all Wall Street ratings issued on stocks were either "buy" or "hold." They almost never issued "sell" ratings.
What was most shocking, however, is how common it was for Wall Street analysts to continue to lavish praise on a stock, even if the company was on the verge of bankruptcy. To better quantify this phenomenon, Weiss Ratings conducted a study on 19 companies that filed for Chapter 11 bankruptcy in the first four months of 2002 and that were rated by Wall Street firms.
The result: Among these 19 bankrupt companies, 12 received a "buy" or "hold" rating from all of the Wall Street firms that rated them. Furthermore, the failed companies 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, Weiss Ratings 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, 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 her recommendation would have lost 98% 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%; Amazon.com, 95%; Drugstore.com, 99%; and Homestore.com, 95.5%.
Why did Ms. Meeker recommend those dogs in the first place? And why did she stubbornly stand by her buy ratings even as they crashed 20, 50, 70, and, finally, as much as 99%?
One reason was that 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."
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% 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% 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% of their money when 24/7 Media crashed.
Subsequently, the Securities Exchange Commission and other regulators agreed to a global settlement with 12 of the largest Wall Street firms with the aim of encouraging independent research and preventing these issues in the future. "Sell" ratings became a bit more common. But the traps laid for investors changed very little. And independent research never got off the ground. More importantly, the global settlement failed to prevent the next ratings fiasco.
Ratings Fiasco 3
Debt Crisis of the Late 2000s
Fast forward to March 14, 2008, the day that Bear Stearns collapsed. The Federal Reserve Bank of New York provided a 28-day $29 billion emergency loan and Bear Stearns signed a merger agreement with JPMorgan Chase in a stock swap worth $2 per share, or less than 10% of Bear Stearns' most recent market value at the time. The sale price represented a staggering decline from a peak of $172 per share as late as January 2007 and $93 per share just two months earlier.
Wall Street stock analysts, still feeling some of the repercussions of their earlier fiasco, were now a bit more willing to issue negative opinions. But the Wall Street bond rating agencies — Moody's, S&P, and Fitch — persisted in their old ways:
On the day of the Bear Sterns failure, Moody's maintained a rating for Bear Stearns of A2; S&P was equally generous, giving the firm an A rating until the day of failure; and Fitch liked Bear Stearns even more, saying it continually merited a solid A+ throughout the 18-year period between February 2, 1990, and March 14, 2008.
Investors lost everything.
When Bear Stearns went under, they said it caught them by surprise, and they couldn't be blamed for not foreseeing what no one expected. But 102 days before the failure, based on publicly available data, we warned that Bear Stearns "had sunk its balance sheet even deeper into the hole, with $20.2 billion in dead assets, or 155% of its equity; and was threatened with insolvency." Moreover, we were not the only independent analysts issuing such warnings.
Six months later, on September 15, 2008, it was Lehman Brothers' turn to go under, driving down the Dow Jones by over 500 points, the largest single-day drop since the days following the 9/11 attacks.
As I showed you in a prior article, it was the landmark event that marked a new, more advanced phase of the debt crisis, sending shock waves of panic around the world that have continued to reverberate to this day.
On the morning of its failure, however, Moody's still gave it a rating of A2; S&P gave it an A; and Fitch gave it an A+. As soon as the news hit, the latter two rating agencies promptly downgraded the firm to D. But for investors trapped in Lehman Brothers shares and for lenders stuck with its debt, it was far too late to take protective action.
Again, investors lost everything. Again, I repeat my warning about their lame excuses: As with Bear Stearns, analysts said they were caught flatfooted due to circumstances no one could have foreseen. But 182 days before its failure, we warned that Lehman was vulnerable to the same disaster that struck Bear Stearns. Nor was that our first warning.
In the prior year, we wrote that Lehman was in a "similar predicament as Bear Stearns" because of an even larger, $34.7 billion pile-up of dead assets, or 160% of its equity. Again, we based my opinion on widely available data; and again, we were among several independent analysts that had reached a similar conclusion.
Meanwhile, Fannie Mae and its sister company, Freddie Mac, were placed under conservatorship of the U.S. government on Sunday, September 7, 2008, with the U.S. Treasury committing to bailout funds of $100 billion for each, the largest bailout for any company in history at that time.
Common and preferred shareholders were wiped out, and debt holders risked suffering severe losses. But because of Fannie Mae's status as a government-sponsored enterprise, the Wall Street rating agencies completely missed it. S&P first gave the company a triple-A rating nearly seven years earlier and never changed it; Moody's did the same more than 13 years earlier and never changed it; Fitch had continually maintained its triple-A for Fannie Mae for more than 17 years and never changed it.
However, independent observers were as persistent in their warnings as Wall Street rating agencies were consistent in their praise.
For example, six years earlier we wrote, "Fannie Mae is already drowning in a sea of debt. It has $34 of debt for every $1 of shareholder equity. That's big leverage and of the wrong kind. Plus, the company has only one one-hundredths of a penny in cash on hand for every $1 of current bills. Think Fannie Mae can't go under? Think again."
Other Fannie Mae critics were not quite that blatant, but reading between their lines, it was clear the true rating the company merited was far from triple-A.
We witnessed a similar pattern of Wall Street complacency, bias, and flagrant disregard for investors with the failures of New Century Financial, which filed for Chapter 11 bankruptcy in 2007; Countrywide Financial, which was bought out by Bank of America in 2008; Washington Mutual, which filed for bankruptcy in September of that year; and Wachovia Bank, which signed a deal to be acquired by Wells Fargo by year-end 2008.
And, in the next great recession, brace yourself for similar shocks.
Lessons to Learn and Never Forget
The New York Times said Weiss was "the first to see the dangers and say so unambiguously." But we were rarely the only ones. Other independent analysts also saw the dangers and also issued warnings.
Nor did it take special intelligence or foresight to do so. Again, as in all prior episodes, the most powerful research tool was available to anyone who bothered to use it — the zealous rejection of payola, conflicts of interest, and bias.
For investors and savers like you, however, the egregious failure of Wall Street to warn of trouble is an extremely important learning experience:
Lesson 1: You cannot trust the established rating agencies such as S&P, Moody's, Fitch and A.M. Best. Regardless of regulatory reform, their business models have not changed. Until they do, take their ratings with a grain of salt, relying primarily on providers of truly independent ratings, such as Bloomberg, Morningstar, TheStreet.com, Value Line, Weiss Ratings, Zacks and others.
Lesson 2: Size alone is no assurance of safety. Quite the contrary, often the bigger the companies are ... the more elaborate the cover-ups ... the harder they fall ... and the more difficult it is for authorities to protect consumers, pick up the pieces, or clean up the mess.
Lesson 3: Even in the best of times, large financial failures are possible. In a severe recession or depression, they are inevitable.
Lesson 4: Inflated ratings played a key role in supporting a speculative bubble. Their downfall could play an equally important role in deepening the next recession.
These are the lessons that should have been learned by Wall Street — and by Washington — long ago. They should have learned them in the 1980s when hundreds of banks failed, in the 1990s when giant insurers failed and in the early 2000s when so many tech companies left investors with deep financial wounds. But they have not learned these lessons of history. And they are destined to repeat it.
Next week: the least understood risk of all.
Good luck and God bless!
The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.