Bill Gross had a go at the rating agencies this week, as always he has a lot of sensible things to say.
The point he didn’t make clearly (he did make it, but it was in-between a discussion of working ladies of the night and six-inch heels…(where does he get his information?)), was that rating agencies have a monopoly franchise to “protect” the world financial system.
It’s as if McDonalds, Burger King, and KFC were the mandated sole-suppliers of school-meals throughout the world, except instead of “protecting nutritional values,” the rating agencies “protect the financial system”…from “surprises.”
The reason there are rating agencies and that they are at the hub of one financial disaster after another (from Enron, to World-Com, to Sub-Prime, to Lehman, to Greece), is because the whole infrastructure of financial regulation hinges on them.
Under all the systems of financial regulation outside of Zimbabwe and North Korea, including, and in particular the much vaunted Basel II Guidelines which were more or less in place just in time to claim credit for the 2008 financial collapse, the “Risk Weighting” of a bond is determined by it’s rating.
So for a bond to have any value, it has to have a rating. That’s important for “financial stability,”, particularly since insurance companies and pension funds are obliged under the law to have a certain proportion of their assets in AAA securities. It’s like a quality control stamp mandated by the regulator, and once you have the stamp the pension funds and insurance companies are obliged to buy that rubbish.
Very nice too (for the purveyors of toxic assets).
A good explanation of how that all works is a recent article by Rortybomb.
The flip side of that is the risk weighting. If you got a AAA bond paying 4% you can finance that at a gearing of 1:49 (theoretically…Lehman only went to 1:30 “officially”), and borrow the rest from the Fed discount window at 0% or thereabouts…(that’s how the TBTF are “earning their way out of trouble”).
The point is that a rating is an “Opinion of Value”, and anyone who has any common sense (what Gross calls the CQ Index) knows that in any transaction you have two opinions of value – one on the side of the seller and one on the side of the buyer.
Then you negotiate.
The purpose of a rating is to provide a THIRD opinion, which is the opinion of the all-powerful regulator.
So the purpose of a rating is simply to work out if a bond complies with the idiotic standards of the regulator that are in place at the time, which have been proven time and time again to be as useless as many of the ratings they mandate and approve.
If you want to see something truly idiotic, the sort of tribute to the Monty Python of Financial Regulation, have a read of the BIS Guidelines.
It’s hilarious; in 251 pages they mention the word “Value” 150 times, but they never explain what “value” is, or how you measure it.
So what is “Value”?
Value according to BIS is what the Fed bought all those toxic assets for, value is what those Greek bonds were worth after “God’s Workers” had done their magic, value is mark-to-market on the way up a bubble, and mark-to-myth on the way down.
The point of course is that the Rating Agencies don’t do valuations, what they do is get paid money to put AAA stamps on things, and the more money you pay them the more stamps you get. Melamine tainted milk - Goldman CDO...no problem!!
That’s why in July 2003, International Valuation Standards (who actually know how to do valuations), wrote to The Bank of International Settlements to tell them that the valuations that were being used (i.e. by the rating agencies), were completely and totally absolutely useless.
There is no record of any response to that letter, although actions speak larger than words--basically it was ignored.
So you have an independent body (IVSC is a UN NGO dedicated to setting valuation standards that make sense), ignored by The Bank of International Settlements (and all the other banking regulators in the world).
And BIG SURPRISE…the collateral posted by the crooks to back-up the silly AAA ratings, proved to be worth a lot less than what was lent at the time that the lenders came to cash it in (after the borrowers decided not to pay the money back).
BIS, the SEC, FASB, IFRS, and all the other geniuses, including the rating agencies would like to tell you that was a BIG SURPRISE.
It wasn’t. It was obvious from the beginning.
What happened in Greece was nothing new, it was simply another example of the corruption of the World Financial system, thanks to the “guidance” of BIS.
So what’s the difference between a Moody’s (NYSE:MCO) Valuation and a valuation done according to International Valuation Standards (IVS)?
Under IVS you are supposed to explicitly state the purpose of the valuation. For example if the purpose was to rip-off a bunch of dumb German bankers by getting them to take the long side of a dodgy CDO as a way to “pass the parcel” of silly insurance policies (CDS) that Goldman Sachs (NYSE:GS) had sold to John Paulson, (and they wanted to get rid of their exposure)…then you are supposed to explicitly state that, like write it on top of the valuation (or rating), in plain English (or German).
If you get an “approved” rating agent to do that, you don’t have to.
The reason IVS requires you state the purpose is that the value of something depends on what you want use it for. For example if you buy a house, you want to know you are paying the right price…today (and the bank wants to know that you don’t have a side deal with the seller so you can get a bigger mortgage – or at least it ought to).
But the bank also wants to know (if it has any brains), how much it can reasonably expect to sell the house for (in the event you jingle-mail them the keys and run away), at some unspecified time in the future. That’s not always the same value as what you paid, today.
2: Market Disequilibrium
Under IVS you are supposed to examine whether the reference market is in disequilibrium or not, and if there is evidence that it is (for example in the housing market in the USA, if the IMF, The Economist Magazine, and Professor Shiller are all saying there is a bubble), you are supposed to work out how much the house could reasonably expect to sell for in the future (like about half the price the suckers paid today), and explain that to your client. A rating agency has no legal or moral obligation to do that.
3: Explaining how you did it
Under IVS you are supposed to explain how you did the valuation to your client, and to anyone who is expected to rely on the valuation. For example if you are doing a valuation of some RMBS you are supposed to provide the base data on those, plus sufficient (note the word “sufficient”) market-derived data on comparables (so that in the case of a pool of RMBS anyone can run a multivariate regression analysis to check the answer).
A rating agency has no legal or moral obligation to do that, and in fact they are not even obliged to do the necessary analysis or collect sufficient data (and they didn’t and they don’t – all they do is say “let’s assume” (“the world is flat” or something equally asinine)).
4: Independence of the Valuation
Under IVS you are not supposed to change the answer depending on how much money you get paid, or the likelihood of getting more (very lucrative) work from your client. If you are an approved rating agency, that is absolutely fair-play (in fact it’s the whole point).
The Bank of International Settlements was set up to extract from Germany the reparations agreed in the Treaty of Versailles, which was what caused the hyper-inflation of the Weimar Republic.
But then they came to an “accommodation” with Hitler, who continued to “co-operate” with them during the war, handing over the gold looted from banks in Belgium and France (which was returned) and gold extracted from the teeth of concentration camp victims (which was not), to keep his credit good.
It was on such foundations that the current financial system was built. Do you wonder why it doesn’t work?
Disclosure: No Positions