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I’ve been re-reading the Michael Lewis book “The Big Short” and it has been making me upset. And what I’m upset at is that the rating agencies are still in business today.

Here is an excerpt from the “Big Short”:

“To judge from their behavior, all the rating agencies worried about was maximizing the number of deals they rated for Wall Street investment banks, and the fees they collected from them. Moody’s once a private company, had gone public in 2000. Since then its revenues had boomed, from $800 million in 2001 to $2.01 billion in 2006. Some huge percentage of the increase–more than half, certainly, but exactly how much more than half they declined to tell Eisman–flowed from the arcane end of the home finance sector, known as structured finance. The surest way to attract structured finance business was to accept the assumptions of the structured finance industry. “We asked everyone the same two questions,” said Vinny. “What is your assumption about home prices, and what is your assumption about loan losses.” Both rating agencies said they expected home prices to rise and loan losses to be around 5 percent –which, if true, meant that even the lowest-rated triple-B, subprime mortgage bonds crafted from them were money-good.” it was like everyone had agreed in advance that five percent was the number,” said Eisman. “They all said five percent. It was a party and there was a party line.”

I actually take back calling these companies useless; dangerous might be more accurate.

When do you hear about a downgrade from a ratings agency? About six months too late if you are lucky.

Every second day now we seemingly get a downgrade of a European bank or European country. That would have been helpful three years ago; today, not so much.

Here is Bill Gross of Pimco commenting on the usefulness of the rating agencies in 2010 when they still held Spain as a AAA credit:

“Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three, benefiting from their timidity and lack of common sense,” Gross wrote. “Take these recent examples for instance: S&P just this past week downgraded Spain “one notch” to AA from AA+, cautioning that they could face another downgrade if they weren’t careful. Oooh – so tough! And believe it or not, Moody’s and Fitch still have them as AAAs. Here’s a country with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels, and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out. Some AAA!”

Don’t you wish you had bought some long term Spanish debt in 2010? I mean it was rated AAA so there was virtually no risk according to S&P. Instead the downgrades on Spanish debt arrive when everyone with electricity and a television already know about the elevated risk.

Do you remember Enron? Enron’s credit rating was still considered investment grade four days before the company declared bankruptcy.

I guess we shouldn’t be surprised about a case like Enron. After all it is Enron that pays the rating agency to provide a rating on the company. Can you say conflict of interest?

The part from the Lewis book that really bothers me though is how these agencies botched up on structured finance products. How much wealth was destroyed globally by investors relying the AAA rating from a ratings agency when making a decision to invest in residential mortgage-backed securities?

These AAA rated securities in many cases consisted solely of BBB rated mortgages, but when pooled together into CDOs were assigned a AAA rating. The strength of the CDO was not dependent on the quality of the underlying loans, but rather the structure of the CDO.

Quite a magic trick. Get a bunch of BBB mortgages, join ‘em to together and presto-chango we have and investment for widows and orphans.

The magic trick was based on worst-case assumptions meant that only the very lowest tranches of these securities would suffer losses. The basic premise was that housing prices could not suffer more than 5% declines nation-wide. What should have been used was common sense, which would suggest that a thousand BBB loans lumped together does not change the fact that they are all BBB loans.

Without those AAA ratings there is no way the housing bubble gets out of hand the way it did. It is beyond me how the ratings agencies which were at the very core of the problem emerge out the other side of the crisis and are still allowed to operate virtually unscathed.

As I said, useless is being too kind. They should have all suffered the same fate as investors who relied on AAA ratings attached to garbage loans. And that is why you will never catching me owning the shares of one of them.

Source: Is There Anything More Useless Than A Rating Agency ?