Enough With the Blame – It’s Time fo Find a Solution to the Rating Agencies' Problems

It is too easy to blame this crisis on just the mortgage brokers, the banks and the borrowers. But it is not that simple. A disaster of this magnitude has many guilty parties.

First on the hit parade are Alan Greenspan, Ben Bernanke, and the entire Federal Reserve Bank. Some of the fault lies with the easy money policy of the Greenspan years. The system is now choking on all that easy credit. Under his watch, Alan Greenspan allowed the unsupervised proliferation of obtuse and opaque mortgage products. The Federal Reserve has the power in its charter to supervise the creation of new products and they chose not to exercise it.

The Federal Reserve are not the only people who were drinking too much at the punch bowl.The largest blame for this crisis falls on the rating agencies, Standard and Poor’s and Moody’s. When is an AAA rating not really AAA? Almost always. The rating agencies are doling out AAA ratings like the elementary school teacher gives out gold stars.

The craziest thing about this crisis is that most of the bonds that are now worthless were rated AAA. Investors mistakenly thought that they were buying bonds with the equivalent rating of US Treasury bonds instead they were buying junk.

Without a default by the issuer, a AAA bond that was worth 100 four months ago is now worthless or more accurately can not be valued. That is scary to me.

The system for rating agencies and the use of ratings is so broken that many think it needs to be thrown out in its entirety and a new system designed. Indeed, the European Commission has started an investigation into the rating agencies. They are investing whether they adequately alerted investors to the risks of mortgage backed securities. The investigation will be lead by the internal markets commissioner, Charles McCreevy.

The rating agencies appeared to be asleep at the wheel. Even though the problems were bubbling to the surface much earlier, the rating agencies were slow to issue credit downgrades.

The current system is rife with conflicts. The rating agencies are paid by the very people that they are supposed to be overseeing, the issuers of bonds. The European Commission would like to abolish these payments. They would like the rating agencies to be paid by the users of the rating agency research. The European Commission plan might too radical to implement right away. They may have to settle for a revision of the code of conduct.

In my opinion, the biggest mistake of the rating agencies is their use of letters instead of numbers. Numbers provide a more accurate pinpoint description than words or letters. A blonde can be platinum, honey or ash while the score of 100 will never be confused with 99. Who, besides the Fab Five on the “Queer Eye”, can distinguish between buff, beige and wheat?

Even librarians, the most ardent lovers of words, chose numbers to catalogue their most precious possessions.

A number system would be easier to use. 100 would be US treasuries. 99 might be the appropriate rating for government agencies, Freddie Mac and Fannie Mae. Not all government agencies are direct obligations of the US treasury. Some only have the ability to draw on Government credit lines. The current letter system can not differentiate those subtleties for the investor.

The maximum score for corporate bonds should be 98. Regardless of the stature of the company or its chairperson, a corporation does not possess the same unfettered ability to raise income (taxes) as the United States Government and they face more event risk. Since 2002, at least three corporations have lost their triple AAA rating – Merck, AIG insurance, and Bristol Myers.

A numerical system would not only be helpful at the high end of the quality curve but also with distressed bonds. Instead of blanketing all bankrupt bonds with a dreaded D rating, numbers would add the flexibility of distinguishing between bankrupt bonds with assets and those devoid.

The rating needs to tell the unabridged story of the issuer not just the cliff notes version. Rating only the ability of an issuer to repay proved to be insufficient and only told half the story. The market value of certain AAA bonds in the absence of liquidity was zero. The rating criteria should encompass parameters like liquidity, transparency, and event risk. The rating of Berkshire Hathaway needs to reflect that the seemingly irreplaceable Warren Buffett is seventy seven years old and close to retirement

The rating agencies rarely differentiate by maturity. Is it really feasible to rate a bond AAA that has a 40 year maturity? It is unlikely that the rating agencies have a good enough crystal ball to predict that far into the future.

Even more confusing than the letter rating system is the descriptive words attached to denote the future direction of the credit. It is impossible to quantify words like positive indications or the even more opaque stable. These words could be replaced with fractions. Bond investors appear to be drinking from the same pitcher of cool aid as the followers of Jim Jones. They blindly follow the rating agencies without asking any questions. They need to be doing more independent due diligence.

There is plenty of blame to go around. We need to stop the recriminations and get serious about fixing the problems with the rating agencies. The European Union has started the investigation. It remains to be seen if the United States will cooperate or continue to protect the rating agencies.

Comments

[rip:]

Nice call on Apple.

How are you still employed?

2007 Dec 27 01:57 PM