Can Credit Ratings Agencies Be Relied Upon to Gauge Systemic Risk?

|
 |  Includes: FMCC, MCO, SLM, SPGI
by: Glen Bradford

Standard & Poor's (McGraw-Hill (MHP) Subsidiary)

Recently, this $11B company made a $2T calculation error and sent markets reeling.

Zooming In

The real reason behind the serial debt downgrades is the political situation. In the past, when governments default, it tended to be a result of their financings in global currency markets and the depreciation of their own currency. That's what happened to Poland when the Zloty crashed and a large chunk of their real estate market was financied on the global currency market. The debt became unservicable. In the United States, we are a currency issuer, and since we issue debt in our own currency and the only 'restrictions' that prevent us from issuing additional currency are self-imposed, the only reason that we would default is that we would choose to default. Politicians lately have had a fun time being ridiculous and their gross negligence regarding what is important has caused multiple global ratings agencies to downgrade our debt rating.

Moody's (NYSE:MCO)

In 2008, Moody's retrospectively was misrating subprime mortgage portfolios which were effectively junk-bonds.

Zooming In

When governmental agencies like Freddie Mac (OTCQB:FMCC)and Sallie Mae (NASDAQ:SLM) started subsidizing mortgages at historically low interest rates with little to no money down on variable rate, back loaded mortgages to people who couldn't afford the beginning interest payments -- red flags should have been raised at Moody's. They were not. It was the best of times, it was the worst of times. It was the best of times for people who could effectively live FAR beyond their means at the expense of banker stupidity -- Ignorance is bliss. It was the worst of times for investors who were investing in these loan portfolios -- and unfortunately that group of investors was effectively the global banking system.

Supplementary Only

Ratings of ratings agencies have been used as the "be all, end all" of risk management in certain instances. The proliferation of mutual funds and ETFs have only fed the fire. Prestigious investors like Warren Buffett exited the names when their ratings were suspect. Arguably, ratings agencies cannot be relied upon to guage systemic risk. So the question is, how do you guage systemic risk if you want to get down to the nitty gritty and understand if the loan portfolio you just bought has the potential to blow up in your face? My advice is to check out Credit Default Swaps (CDS). A few recent examples include this, this and this.

Systemic Risk

Systemic risk is often more important to an investor than any other type of risk and it is also the hardest to assess. How does one begin to project the true risk when markets still don't realize that everyone is in the same boat playing the same game and the jig is almost up? If you are familiar with Black Swan logic and that systems of people tend to be overconfident until proven otherwise, and that this overconfidence prevents them from seeing true intrinsic risk, then you are leaps and bounds above your peers. That said, if this is the case, how did you fare in 2008?

Addendum

The question has recently been proposed: "Those in power can trigger, but can they sustain?" My answer is: In the short-term, yes. In the long-term, no.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.