Why Are Ratings Agencies Still Relevant?

 |  Includes: ERO, FXE, GRDOW, MCO
by: Clemens Kownatzki

The grilling of Goldman Sachs (NYSE:GS) executives during yesterday’s Senate hearings offered a fascinating insight into some of the workings of the world’s most sophisticated investment bank. At times, it felt like the questioning senators received a lesson in market-making 101. Trying to be as non-judgmental as possible, I still came to the following realization: There is a difference between knowledge and wisdom, one that could be characterized by humility or the apparent lack thereof in the case of some financial heavyweights.

Whether those executives were guilty of any wrong-doing and responsible for some of the causes of the financial crisis or not remains questionable. The market seems to have given the thumbs up in favor of Goldman Sachs, whose stock is up over 2% today.

But the hearings also revealed a bit of an insight into the complex nature of the interactions between investment banks and ratings agencies. At this point, one can only guess how massive the numerous conflicts of interests were and still are, that allowed some of the most obscure financial products to be sold with an official stamp of approval and an “A” rating. At the basis of this conflict of interest is the simple fact that the ratings agencies are (still) being paid by those institutions who are to be rated, or whose products are to be rated.

Despite all the negative press, the ongoing investigations and a serious backlash from investors, the markets still seem to follow the recommendations of these agencies.

It is therefore not surprising to see how Greek debt suffered a free fall recently. After a series of rather “timely” downgrades by the ratings agencies, most recently by Standard & Poor’s today, the yields on 2-year Greek government bonds topped 21% today, way above that of the most notorious and riskiest of sovereign debt issues. As the New York Times reports:

The ratings agency Standard & Poor’s lowered the debt rating of Spain on Wednesday, its third downgrade of a European country in two days. The downgrade came one day after the S.& P. cut the ratings of Greek and Portuguese debt, moves that set off a flight by investors away from global equities and into fixed income securities, particularly those in United States dollars. The news Wednesday set off no such reaction, although an index of Spanish stocks fell about 3 percent. The S.&P. downgraded Spain’s debt one step, to AA, with a negative outlook.

At one point, the Greek 10-year yield reached 12.5% when just 6 months ago it was below 5%. What has changed in terms of the Greek economy and finances that wasn’t clear to the ratings agencies then? One should be rather concerned about the apparent inability of ratings agencies to better assess the credit worthiness of their targets.

The US exposure to Greece sovereign debt is relatively small. However, as the debt crisis is spreading to other countries with the downgrade of Spain today, one must wonder what comparative metrics are used that make the distinction between what is still considered the “risk-free” rate in the US and other sovereign debt yields.

Disclosure: No positions