Financial analysis is not only done by managers of a firm but by outside analyst

Question

Financial analysis is not only done by managers of a firm but by outside analysts as well. These outside analysts normally supply data to stock market and debt market investors. One of the great problems detected after the great bull market of the 1990s and continued to be a concern during the more recent financial crisis (2008) is that many analysts are not always as objective as they should be. (For example, the rating agencies - S&P, Moody's, etc. are in fact paid by the companies for whom they are doing the rating. Could this be a conflict of interest?)

Reflecting back on these two periods of economic contraction, and looking at the recent run-up of the market to historic high levels, what sorts of dysfunctional analytical practices occurred? What firms were involved? Why do you think these practices were prevalent? Have any controls been put into place to address the issue? Are additional controls warranted?

Explanation / Answer

Yes, outside analysts tend to subjective most of the times and this subjectivity arises due to several reasons. The reasons can be different valuation methods being used, different perceptions with regards to outlook of the company and different thinking patterns. However in many cases the outside analysts are being paid by the very company that they are analyzing. For instance rating agencies are being paid by companies for whom they determine ratings. This is a significant ‘conflict of interest’ and in many cases rating agencies are encouraged to reduce the element of objectivity and increase the level of subjectivity in their analysis.

Referring back to the two periods of economic contraction the dysfunctional analytical practices that occurred was that of biased ratings. For instance the big rating agencies assigned triple A ratings of mortgage related securities. These mortgages related securities formed CDO (collateralized debt obligations) before the financial crisis of 2008.

To address the issues SEC have introduced regulations to ensure that, going forward, the ratings are not flawed and the methodologies being used by the rating agencies are transparent. The implemented changes have made it all the more difficult for rating agencies to assign high ratings to securities like CDOs. At this point of time additional controls are not warranted but as market evolves and new financially engineered debt and equity instruments are being issued the regulatory bodies will have to consider developing additional controls keeping in mind the requirements of changing times and introduction of new financial instruments.

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