Like what you've read?

On Line Opinion is the only Australian site where you get all sides of the story. We don't
charge, but we need your support. Here�s how you can help.

  • Advertise

    We have a monthly audience of 70,000 and advertising packages from $200 a month.

  • Volunteer

    We always need commissioning editors and sub-editors.

  • Contribute

    Got something to say? Submit an essay.


 The National Forum   Donate   Your Account   On Line Opinion   Forum   Blogs   Polling   About   
On Line Opinion logo ON LINE OPINION - Australia's e-journal of social and political debate

Subscribe!
Subscribe





On Line Opinion is a not-for-profit publication and relies on the generosity of its sponsors, editors and contributors. If you would like to help, contact us.
___________

Syndicate
RSS/XML


RSS 2.0

AAA ratings: a 'grim' fairy tale

By Addison Wiggin - posted Tuesday, 7 September 2010


How the ratings agencies have managed to emerge from the credit crisis unscathed and unregulated is a mystery ... and a sham.

"Nothing is ever clear or certain in public," we wrote in The New Empire of Debt. "Every error is someone else's fault. That is why so many men prefer it. The public world is so surrounded in fog that he thinks he sees half-naked nymphs behind every tree and $100 bills under every cushion."

If Wall Street is a foggy valley of shadows where wise bankers pick the pockets of the wandering masses, then rating agencies act as the surrounding hilltops. No - not the pillars of transparency and relief from the villains below. Rather, they're the unscaleable, daunting cliffs that trap and thicken the fog. (This is the case almost literally, in fact. Moody's, Standard and Poor's and Fitch Ratings' major offices surround the lowest tip of Manhattan eerily ... Moody's to the west, S&P at east and Fitch at the southernmost point of the island.)

Advertisement

While it is the duty of ratings agencies to assess investment risk and provide a clear playing field for investors of every kind, we all know that they have done just the opposite. From mortgage-backed securities to municipal bonds, sovereign debt to CDOs, ratings agencies have notoriously mispriced risk over the last decade, and nearly all of us have paid the consequence.

Yet they not only remain, but prosper. They're still used by every major firm in America (if not the world). And they're left largely untouched by regulators and investigators. Why?

Last month, a long-running Senate study determined that over 91 per cent of the AAA mortgage-backed securities issued from 2006-2007 have since been downgraded to "junk" - BB or lower. Surely, a screw-up this gigantic can only be attributed to some extremely smart people. A man off the street would have better odds just flipping a coin. Only geniuses can be so, so wrong.

In fact, that's the best explanation for what happened to the "big three" ratings agencies. They were run by brilliant quantitative economists, with models derived from statistics dating back decades. Whether the housing statistics from the Great Depression were lost, or if the raters willfully left them out of their models, we don't know. But there was no model in use that took into account a generational crisis - one where home prices might drop 20 per cent in one year. So investment bankers were able to stuff securities full of bad loans and still get their precious AAA ratings.

"Their quantitative models appeared to have a Mensa-like IQ of at least 160," bond legend Bill Gross sums up nicely, "but their common-sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them."

"It's easier to be smart than good," we also wrote in Empire of Debt. "Smart men get elected to high office. They run major corporations ...

Advertisement

"But it is virtue, not brainpower, that pays off."

Of course, all the raters and bankers were more than just too smart for their own good. Their lack of virtue exposed a conflict of interest obvious to any functional adult:

  • investors want AAA-rated securities;
  • investment banks deliver whatever their clients want;
  • investment banks pay ratings agencies for their services;
  • the service of a ratings agency is to rate securities.

You can pick your metaphor. It's like a student who pays his teacher to grade his papers. Or a plaintiff paying the judge's salary.

Cultural differences only exacerbated the problem. Investment bankers might pay the ratings agencies, but it's the bankers - by selling those securities the agencies rate - who make the big bucks. It's quite common for a junior man at a ratings agency to one day work for Goldman Sachs or JP Morgan (though not the other way around).

Thus, there is further incentive, though widely unspoken, for raters to play ball. After all, what's the Wall Street life expectancy of an S&P analyst with a ball-busting, no-games reputation? (This same relationship, by the way, is also a real issue with the SEC.)

And so the game was played. Together, the rater and banker would decide what combination of loans garnered what rating. Of course, the banker wanted AAA notes to sell to the Icelandic government or a Fidelity retirement fund, and the rater wanted the banker's business ... if not to become a banker himself one day. The models played along, too, having never known a crisis like the one that was around the corner.

Even when things got really crazy - when there were just way too many bad loans to make a AAA security - bankers and raters found a solution. They split the security into different partitions of risk, each with separate yields, but all under the same rating. They called these "tranches," as if it weren't complicated enough - a French word for a "slice" or "portion".

Shareholders and taxpayers, of course, paid the biggest price for the subprime fallout. Bankers have taken a few jabs, too ... sort of. But ratings agencies managed to emerge largely unscathed. The big three, Moody's, Fitch and S&P, are not only still in business, but they remain highly relevant.

Even as we write, traders are waiting to hear from them with bated breath ... the fates of debt-strapped euro-nations, Greece in particular, is in their hands. S&P likes to boast that they insist on sending not one, but two ratings analysts to every country to help determine its credit sovereignty. "It's been our practice, and it's worked well," said S&P's John Chambers.

S&P rated Iceland "A+" in March 2008, about six months before its currency collapsed.

Late last month, Chambers helped knock Spain down to AA, a "bold" move, defying Moody's and Fitch's AAA rating on Spanish debt. "Here's a country," Bill Gross continues, "with 20 per cent unemployment, a recent current account deficit of 10 per cent, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!"

That's the biggest bond investor in the world calling agencies out with a crystal-clear example of their inability to function. Yet global credit still lives and dies by their ratings.

Despite all the obvious, common-sense issues - incompetence, conflict of interest, past performance - Congress is turning a blind eye to this tawdry corner of the financial services industry.

Even the free market seems to have failed in this instance. There are more than just three ratings agencies in this world, after all. Some of them even managed to do their jobs. "Second tier" agency Egan Jones comes to mind. Its analysts are paid by the buyers of the securities it rates, not the issuers. What a novel idea! Yet Egan Jones is not the No 1 agency in the world, for reasons we can't explain.

Even if American investors are content to continue this charade, the Chinese are not. An upstart Chinese ratings agency, Dagong Global, has begun to offer a competing perspective. (Check out the rating on lucky nation #13 in the chart below!)

Insert chart

There's one easy takeaway: you still can't trust Wall Street. The same players and the same rules that created this mess - largely for their own benefit - are still a part of the game.

The other pill is a little harder to swallow. In the current market environment, the individual, independent investor has the best chances of long-term capital appreciation when he invests outside of "The Wall Street Fandango". When it comes to the truly important investments in life, leave the indexes, blue chip stocks, sovereign bonds and super funds to lower Manhattan.

Ratings agencies and their banker clients do not bother with small companies, commodities, smaller funds and other securities that have little potential to make them large amounts of money. What's more, they have no stake whatsoever in the status of your small- to medium-sized business, your family, your education or your local under-the-radar investments.

It's in these arenas, where Wall Street has no dice to roll and no purses to snatch, where your failure or success is determined by little more than willpower, wit and some luck. That's the best a good investor could ask for.

  1. Pages:
  2. 1
  3. 2
  4. 3
  5. All

First published in The Daily Reckoning on August 31, 2010.



Discuss in our Forums

See what other readers are saying about this article!

Click here to read & post comments.

1 post so far.

Share this:
reddit this reddit thisbookmark with del.icio.us Del.icio.usdigg thisseed newsvineSeed NewsvineStumbleUpon StumbleUponsubmit to propellerkwoff it

About the Author

Addison Wiggin is the editorial director of The Daily Reckoning, and executive publisher of Agora Financial. His second editions of international best-sellers Financial Reckoning Day Fallout and The New Empire of Debt. His third book, The Demise of the Dollar ... and Why it’s Even Better for Your Investments was updated in 2008, the same year he wrote I.O.U.S.A.

Creative Commons LicenseThis work is licensed under a Creative Commons License.

Article Tools
Comment 1 comment
Print Printable version
Subscribe Subscribe
Email Email a friend
Advertisement

About Us Search Discuss Feedback Legals Privacy