The Rating Agencies Are Dead: Long Live the Rating Agencies

May.16.10 | About: Moody's Corporation (MCO)

Once upon a time, rating agencies were independent research companies advising end-buyers and traders on the fundamental value of securities. They sold opinions of value, i.e. they did valuations – they gave an opinion on how likely it was that projected cash flows would materialize in the future; and once you got a fix on that, working out present value is just arithmetic.

The trouble started when regulators decided to hitch a free ride on the backs of the rating agencies; they mandated that capital adequacy was assessed based on ratings provided by approved agencies.

Fair-enough,, that’s sounds “innocent”, and sensible; if a bank has a lot of high quality assets then the capital cover that they should be obliged to hold, can reasonably be less than a bank that has a load of low quality assets. And who better to work out the quality of the assets than rating agencies, they were in that business, in the private sector, making money providing opinions to industry experts?

So the rating agencies just kept on “giving opinions”, except that there was a conflict of interest because their client base switched from being (mainly) the buyers of securities, to the sellers.

And there is always more money to be made sitting on the seller’s side of the table than on the buyer’s side…much more money. If you get “X” percent of a deal that goes through, that is always more than the lump-sum you get paid for advising against a deal, and you never get paid for the deals that don’t happen.

Imagine sending someone an invoice, “in respect of the $1 billion deal that I persuaded you not to get into, that tanked, here is my fee for 1%”. That’s just ludicrous. But turn that around, “with regard to the $1 billion deal that you did thanks to my wonderful explanation of how I reached my opinion about what a good deal it was that all the investors lapped up, here is my fee for 1%. Now that’s fair enough…everyone made money right?

The huff and puff of the SEC et al, going after the rating agencies is a red-herring. It was the regulators who depended on the rating agencies, and ultimately it was they, via that sleight of hand, who created the credit crunch.

Forget about President Clinton pushing for home ownership, Bin Laden frightening Alan Greenspan into dropping the base-rate after 9/11 and keeping it down too long, Liar Loans, naked credit default swaps, dodgy collateralised debt obligations or greedy bankers. Didn’t you know, all bankers are greedy…and mean. Its part of the selection-process- you have to prove that you loved torturing small animals as a child before they let you into the “association” and their Patron Saint is Shylock from The Merchant of Venice.

But that’s not new, what happened is new: The reason there was a credit crunch was because there was a housing bust.

If there had not been a bust there would not have been a crunch. If there had not been a bust then all those AAA rated RMBS would be performing perfectly, Hank Paulson would have “saved the world” by his “confidence-building” pronouncement that “The U.S. Banking System is a Safe and Sound one”, Lehman would still be alive, ACA would be billionaires and John Paulson would be running a popcorn concession in Detroit.

The reason there was a housing bust was because there was a bubble.

Logic my dear Watson, if there hadn’t been a bubble then there would not have been a bust. The reason there was a bubble was because too much borrowed (and easy) money was chasing too few homes. And the reason there was too much easy-money-chasing-too-few-homes, was because Moody’s & Co (NYSE:MCO) stamped AAA on residential mortgage backed securities tied to the easy money. And the reason they did that was because in the SEC handed out TEN concessions to TEN rating agencies.

They wanted a quality control on securities, but they didn’t want to pay. Can you imagine if BOA presents a list of “assets” and the regulator hires Moody’s to tell them how good they are, and what risk weighting should be applied; and pays them for doing that job? That’s never going to happen, not in a million years.

Rule 436(g)

A good account of how that works was written by Shahein Nasiripour in the Huffington Post.

In return for the rating agencies doing the regulator’s job (for free); they gave them a concession, it was called Rule 436(g). What that meant was that in return for providing ratings that the regulators could rely on (for free), the agencies were awarded a monopoly and immunity from prosecution (civil and criminal), if they made a mistake.

See if you recognize where this came from (from Wikipedia):

Harley (The Lord Treasurer) needed to provide a mechanism for funding government debt incurred in the course of that war. However, he could not establish a bank, because the charter of the Bank of England made it the only joint stock bank. He therefore established what, on its face, was a trading company, though its main activity was in fact the funding of government debt.

In return for its exclusive trading rights the government saw an opportunity for a profitable trade-off. The government and the company convinced the holders of around £10 million of short-term government debt to exchange it with a new issue of stock in the company. In exchange, the government granted the company a perpetual annuity from the government paying £576,534 annually on the company's books, or a perpetual loan of £10 million paying 6 percent. This guaranteed the new equity owners a steady stream of earnings to this new venture. The government thought it was in a win-win situation because it would fund the interest payment by placing a tariff on the goods brought from South America.

Are you starting to get the picture, “perpetual loans…win-win…monopoly…off-balance sheet…shadow banks”? That was the foundation of the South Sea Bubble.

The initial driver of the “concession” that led to the housing bubble was the fact that the State Governments in USA needed financing, but they were not (and are still not) allowed to run a budget deficit. Yet they needed to build sewage treatment plants, and other essentials, and the way to finance that was by issuing securities. And having the rating agencies “on board” was a big help.

And then there was housing. OK, the government didn’t benefit directly, but they didn’t mind if Average Joe and May Lou used their house as an ATM, because that helped the world go round, and that made the politicians look good. Of course they only allowed that so long as the “independent” rating agencies blessed the deals.

So on one hand the regulators mandated that securities should be rated by an approved agency, and on the other hand the approved agencies were simply “giving opinions”….except on behalf of the sellers. So put them in sacks full of snakes and dump them in the oily waters of Louisiana? That’s an idea; that’s what was contemplated after the South Sea Bubble burst by the British Parliament, find someone to blame, punish them, and you feel better.

Except you can’t blame “The Government” because yesterday’s pork is today’s pig-manure, and past governments have absolute immunity. So blame the rating agencies, they gave their opinion, they were wrong, except they were not paid (initially) by the people who (eventually) suffered from their mistakes, and they had no duty of care outside of “trying harder”.

Look at the huff and puff of the SEC throwing fluff at the rating agencies. Moody’s has admitted filling out some forms wrong…WOW…that may of course be a bureaucrat’s wet-dream to have discovered the discrepancy, but so what? Timothy Geithner filled out a few forms wrong in his time.

Notice how the SEC action against Goldman Sachs (NYSE:GS) (on the famous Paulson CDO) did not name the rating agency that stamped AAA on that. The reason is clear, the rating agency has immunity.

Going Forward

Regulators need someone to provide quality assurance on securities, without that the system breaks down, particularly when like now, no one believes in the quality assurance stamps. But quality assurance requires a “bad-guy” who is truly independent. The move to force issuers and holders of securities to use an agency that is determined by the regulator (whoever pays him), is a step in the right direction. But it won’t work, the rating agencies who decide the rating of a bond, needs to be employed by the regulator, AND answerable to him, AND liable for mistakes (PI insurance would help).

That doesn’t mean there won’t be work for the rating agencies providing “opinions” to the sellers and the buyers, but they will be buying just that, opinions, just like in the old days. There are two jobs, the “good-guy” job, and the “bad guy” job, what just happened was that “someone” tried to kill two birds with one stone.

Disclosure: No positions