The Ratings Agencies Will Continue Underestimating Credit Risk

by: The Prudent Investor

I got a strong reminder of the rule that whenever people say something is very complicated, they just want to avoid telling the simple truth. Attending a panel discussion headlined "values worth fighting for" and organized by the Austrian Friedrich August von Hayek Institut on Thursday, panel speaker Daniel Thorniley from The Economist Group summarized the idiocy of investment banking with three figures:

In 2008 there were:

  • 15 nations with an AAA-rating
  • 15 corporations with an AAA-rating
  • 64,000 CDOs (collateraliezed debt obligations) with an AAA-rating

Shut Down the Ratings Agencies

I guess you don't need a computer to find out that there was indeed a 64,000 strong imbalance in a market where the masterminds at the ratings agencies got something fundamentally wrong.

Not that this would damage their track record. Ratings agencies got caught on the wrong foot in the Russian crisis in the mid-90s, the Asian crisis shortly before and only started to cut bank ratings in this millennium when even the shoeshine boys had pulled out of the market already. They did not do any better in the Latin Amercian crisis of the 1980s and the internet bubble of the 1990s.

We can confidently expect that the ratings agencies will continue the well-trodden path of underestimating credit risk. After all, the USA is the biggest debtor in the world and is still AAA-rated although president Barack Obama and his Treasury secretary have to come up with $5 billion every day, seven days a week in order to finance the budget deficit (which could be halved by stopping the 2 wars in Iraq and Afghanistan).

In order to save me some typing, please (re)visit the first post of my blog from April 2005: "US AAA Rating - How much longer???" In this context you may also find the post "The US Debt Balloon - A Simple Explanation for Non-Economists" worthwhile reading.

As the global discussion on new regulations fills many pages of financial media, I have a very simple approach:

  1. Reinstate the Glass-Steagall Act and make a division of commercial and investment banking mandatory worldwide. Countries that do not comply could be simply shut out by not doing business with their banks.

  2. Shut down the ratings agencies for good and let bankers return to their core business: assessing risks on their own. No ratings agencies would mean that bankers would have nobody left for a cheap excuse that it was not their fault.

Signing off for today, still hoping to get an exclusive with the (fallen) god of volatility in the next 3 days.

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