Rating Agencies: Whom Can You Trust?

by Mike Conlon

Ratings Agencies No More?

S&P? Sayonara! Moody’s (MCO)? Muerte! Fitch? You get the idea. Yesterday the Attorney General of California, Jerry Brown, announced that he would be investigating the role the ratings agencies played in helping to cause the Great Recession. And I say it’s about time! For far too long these agencies have had a stranglehold over bond and credit markets and now the jig is up!

While this is nothing new considering the House Oversight Committee came to this conclusion back in an October 2008 hearing, now this opens the door for compensatory damages to be awarded to investors that were defrauded by negligent practices. If these companies do survive, look for increased competition from the investment banks and new regulations that will more properly define how these companies can make money.

Here are some of the former practices which will hopefully be reformed and some of the ways that the ratings agencies should be fixed going forward.

For starters, the ratings agencies were paid by the same companies who insure and put out the bonds that are issued. This obvious conflict of interest led to “bid shopping”, whereby the company that gave the highest rating would be paid the most. This became a particularly heinous act when the highest ratings were given to subprime mortgage-backed securities when the agencies themselves knew those ratings were undeserved.

In this obvious breach of trust and power, many investors were duped into believing that they were buying safe and secure instruments only to find out later that they were anything but. Investment banks who participated in this scheme (yes even you Goldman) should be punished as well.

What this means going forward is that in order to maintain the true independence of these agencies, they have to change the compensation structure. Unfortunately, this means less money for these companies which means they have less money to pay competent employees, thereby exacerbating the “brain drain” that these firms are commonly known for.

The original intent of these firms was to protect the public and they have failed miserably. So what’s the solution?

Clearly there need to be standards in place that are universal to all of the agencies and we need increased oversight by the appropriate authorities. Next, they need to remove the “pay for play” nature of the business and establish standard fees that the industry can charge. Then allow for additional compensation for actually being correct in their assessments. Their function in the marketplace is far too important to allow them to operate with the “weatherman mentality”, and they should be paid based on performance.

Hopefully, the government will come up with a way that these companies can get back to doing what they formerly did best, assessing risk in the markets and not trying to make a quick buck.

But as for right now, I don’t trust them. Who knows what else out there has been wrongly rated.

Comments

[john s. gordon:]

reform is long overdue/
the rating agencies were corrupted by the big fat fees they were getting from the corporations whose junk paper they were supposed to be rating.
> jack

Sep 18 08:52 AM

[Rational pe...:]

Your lack of actual facts is sad. Like every other participant in the markets, including the most brilliant and highest paid investment banks and hedge funds, the rating agencies were run over by the tsuami caused by the confluence of events. The fact is, that ratings are not trading recommendations - they are an analysis of probability of default and estimation of ultimate repayment of debt. These instruments are worthless due mostly to a liquidity squeeze - most of them will ultimately be repaid if held to maturity. When trillions of dollars are lost, market participants will look to blame anyone and everyone but themselves or their own bad investment and trading decisions.


On Sep 18 08:52 AM john s. gordon wrote:

> reform is long overdue/
> the rating agencies were corrupted by the big fat fees they were
> getting from the corporations whose junk paper they were supposed
> to be rating.

Sep 18 10:57 AM

[LKofEnglish:]

nothing more than a criminal enterprise. the internal e-mails were crystal clear: "who's going to buy these things?" I think this was an exact quote done AFTER they were rated triple A so Mr. Rational just like all the rest of wall street is simply lying right to our face just like the rating agencies were. not that an investor needs them, that is true. the government on the other hand, in order to make this jallopy of an economy worth investing in for the foreigners who are the ONLY reason it still exists right now, DOES need quality ratings agencies. NOW!!!!!

Sep 18 02:36 PM

[eiffel:]

Wow!!! You actually praise Jerry Brown the California Attorney General! California??? a state wherre the mortgage brokers were allowed by the regulators to abuse consumers by violating all the rules. A state that actually encouraged unqualified buyers to borrow more than they could afford. A state where the regulators were completely asleep at the wheel! A state that got so high on higher housing tax revenue that it blew up its budget to oblivion and to bankrupcy! Surely, you did not mean to praise Jerry Brown...unless you are smoking the same thing he is.

Sep 18 03:31 PM