Ratings Agencies: Villians or Scapegoats?

Let me start right off by saying I am long one of the ratings agencies. That is a very unpopular position right now as judged by recent stock performance and commentary from all quarters. At least I am putting my money where my mouth is about to be.

A lot of fingers are being pointed at the likes of Standard and Poor's (MHP) and Moody's (MCO) as being at least partially responsible for the debt crisis. I have even heard some pretty smart individuals question the integrity of the raters and the inherent conflicts of interest in their business models. Call me naive, call me a dope, but that bandwagon seems just a little too easy to jump on at the moment.

A quick primer: Moody's et al. issue OPINIONS on the credit quality of all kinds of debt instruments and debt issuers. They are not fiduciaries, but are akin to sell-side analysts on the equity side. The finger-pointers scream that the raters issued AAA ratings on tons of CDOs backed by subprime mortgages that are now defaulting at a furious pace. How could they give these structured debt instruments their highest ratings? Couldn't they see that they were inherently dangerous? Clearly, since the issuers of these CDOs pay the agencies for their ratings, the agencies must have compromised their integrity and pandered to the issuers in order to get more business from them.

Sounds good, but I don't buy it.

First off, the raters are an oligopoly where most serious issuers obtain ratings from both S&P and Moody's. Where is the incentive to pad ratings? The issuers have nowhere else to go - ratings from Moody's and S&P are the defacto standard and the cover charge that issuers know they must pay if they want to get into the "club". Second, integrity is THE major asset possessed by these companies, and believe me they know it. One clear example of them compromising their integrity and they are toast, period. Would they risk destroying 107 years of brand equity (in Moody's case) to appease CDO issuers? I doubt it.

Let's bend some of those pointing fingers backwards and look at the actual fiduciaries now being throttled by this mess. Let's say you run a big pension fund that is restricted to buying AAA-rated debt. It's mid 2006. What can you buy? Maybe some AAA corporate debt, or how about an opaque structured debt instrument backed by subprime mortgages originated by who knows who. Heck, they're all AAA. Give me a big fat heap of those CDOs please! They yield a few bps more than that boring old GE debt. So what if even the tribes of aboriginal peoples living in the New Guinean rain forest know that the US housing market is at an all-time over-heated high, these CDOs are rated AAA!

I guess risk doesn't matter if you're a yield pig. I guess it doesn't matter that everyone on Wall Street knows that pigs get slaughtered. I guess it doesn't matter that everyone on Wall Street knows there is no free lunch - if these things were yielding more than other forms of AAA debt, there was a reason (if anyone knows how much spread they were getting on AAA CDOs vs. AAA corporates, let me know!). That reason is RISK. The real kind of risk - of default.

Back to the raters. Why did they rate these instruments AAA? They were analyzed using models loaded with assumptions based on past experience. Because the CDO's were "diversified" the models predicted that only a small portion would ever default at once. They failed to take into account the worst housing crash since God knows when. Perhaps they should've read Nasim Taleb's 'Black Swan'. But computer models have a real tough time programming in "fat-tail" events. Just ask some of the quant hedge funds about last August, or ask Long Term Capital Management about the truth of this quote by Nobel Physicist Philip Anderson:

Much of the real world is controlled as much by the "tails" of distributions as by means or averages: by the exceptional, not the mean; by the catastrophe, not the steady drip; by the very rich, not the "middle class." We need to free ourselves from "average" thinking.

Bingo! So the raters clearly didn't do a great job of rating these things. Their models were clearly deficient. Not to mention there was a "garbage in " factor at work too. Many many mortgages were being originated with little or no documentation (liar loans) and originators were even falsifying borrower data. Hence, garbage out. Not the ratings agencies' fault really. None of this means they did anything to compromise their integrity. If you were a fiduciary who bought CDOs solely based on their ratings you should be hiding all the mirrors in your house. Heck, that would be like buying stocks simply based on sell-side analysts' buy or sell ratings with no additional research. Just like back in the good old tech boom days. Funny - everyone was pointing fingers at the analysts after that debacle. It was their darn fault, they MADE me buy pets.com!

Alas, humans are preprogrammed to find a scapegoat anytime they are subjected to pain. I urge you to read this article by Professor David P. Barash on scapegoating. As he says,

For as long as there have been human beings on earth ? stretching back to our animal inheritance ? we have been bedeviled by a peculiar need, as insistent as it has been tragic: Making others suffer for the pain we feel, often choosing as our victim someone who wasn't even the original perpetrator.

Much as the number of lynchings increased in the old south when the economy soured, so too does the scapegoating (and lynchings) on Wall Street. The ratings agencies MADE me buy CDO's backed by subprime debt!

But I guess no one could see any of this coming. I mean no one has a crystal ball right? Sure, you could have listened to Bill Ackman of Pershing Square when he gave this presentation (.pdf) in May at the Ira Sohn conference. Ok, so maybe HE has a crystal ball. Or maybe he is just smarter than everybody. Or maybe, just maybe, he is rational and knows how to avoid the pitfalls of social proof, consistency bias and pig-headed herd behavior.

As Buffett said:

Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)

Finally, I note the cognitive dissonance in the press and elsewhere regarding the ratings agencies. In one paragraph, their integrity is being questioned along with their future relevance. In the next, their ratings are being cited as an indication of the credit-worthiness of a company, confirming their relevance. The market hates these guys now, but I simply don't believe they are at fault here or that they have compromised their integrity in any way.

Jim Morrison sang, "There's blood in the street it's up to my ankles". So it is across much of the Market and certainly in ratings agency land. But if I'm right, these prices will look very cheap one day. As Dr. Barash says:

human beings, perhaps unique among animals, are capable, at least on occasion, and once the issues are made clear, of acting against the promptings of their often troublesome bio-logic.

Is this asking too much of Wall Street? Is it a stretch to refer to the Street as human beings? Time will tell.

Disclosure: Long MCO

Comments

[Sr. Pessimist:]

Ratings agencies could rate proletarian vouchers. Soon the rich would be the producers of the economy, not the capital equity severance gangsters. No more capital. That's the future of the dictatorship of the proletariat. I think it will happen here in America. The rest of the world would be forced to follow. True socialism might be the option to still honor currency. But I think vouchers will win in the end. So does Karl Marx. I also agree with him that socialism will never exist. It will just be a transitional description. You gotta be willing to kill to maintain power. The proletarian rulers of the future will be just that.

Must be scary for them to hear me say, "Your capital cannot have my best equity."

2007 Nov 22 10:21 AM

[Sr. Pessimist:]

Oh, and by implying that Karl Marx thinks vouchers will win in the end, I mean to say strictly that he and I both agree that currency-free barter will be the standard of trade. I just think a voucher (a standardized electronic or paper description of a redeemable good or service, or a range of specific goods and services) is the realized form of the transaction medium for barter exchange.

2007 Nov 22 10:25 AM

[Ron Mahabir08:]

Let me start off by saying that I am short one of the rating agencies (Moody's). Did you see the recent 8-K filing on Tuesday? Generally, when sudden resignations occur at this level and for such a relevant position to this crisis, it doesn't bode well for the company (directors at Countrywide, New Century, etc. prior to their implosion).

From a macro view, how can the rating agencies recover from the fastest increase in rating revenues in history in a rapidly deflating credit environment and global slowdown?


Item 5.02, "Departure of Directors or Certain Officers"

Jeanne M. Dering resigned, effective November 14, 2007, from her position as Executive Vice President, Global Regulatory Affairs and Compliance of Moody's Corporation (the "Company"). She will remain an employee of the Company until December 31, 2007.

2007 Nov 22 09:13 PM

[Ron Mahabir08:]

Let me start off by saying that I am short one of the rating agencies (Moody's). Did you see the recent 8-K filing on Tuesday? Generally, when sudden resignations occur at this level and for such a relevant position to this crisis, it doesn't bode well for the company (directors at Countrywide, New Century, etc. prior to their implosion).

From a macro view, how can the rating agencies recover from the fastest increase in rating revenues in history in a rapidly deflating credit environment and global slowdown?


Item 5.02, "Departure of Directors or Certain Officers"

Jeanne M. Dering resigned, effective November 14, 2007, from her position as Executive Vice President, Global Regulatory Affairs and Compliance of Moody's Corporation (the "Company"). She will remain an employee of the Company until December 31, 2007.

2007 Nov 22 09:16 PM

[shewfehe:]

Your article is well thought out. It is mainly sophisticated investors that use the ratings extensively. One would think that those investors would understand that ratings are guides only and not guarantees. Bankers know that even when you have a guarantee you often have to go to court to get the guarantor to pay. By definition, I think those who complain that the rating agencies misguided them are really telling us that they are unsophisticated.

2007 Nov 27 05:30 PM