In recent credit crises one of the culprits that escaped scrutiny as well as public wrath was Rating Agency. Rating Agencies like S&P, Moody’s et al played most instrumental role in inflating the balloon and then realizing their mistake played pivotal role in bursting it. And yet no one seems to blame them for anything. In fact technically speaking, they are the sole culprit of the whole problem. We are blaming Wall Street bosses for their financial wizardry that ultimately consumed them, we are blaming investing funds for investing without due diligence. We are blaming mortgage companies for making predatory loans. And then the blame game shifts to which President should be blamed. But one thing’s is true that apart from the mortgage companies like New Century Finance neither investors nor Wall Street bosses did anything with criminal intent. Of course they don’t deserve any sympathy. But when you invest in a bond because it’s AAA and it turns out that the bond is actually less that BBB (i.e. below investing grade)and this discrepancy is because Rating Agency didn’t do their job well then who do you think should be blamed?
Let’s me try to paint little background for readers to see my argument easily.
Rating Agencies like S&P, Moody’s, and Fitch etc. are independent companies that rate anything and everything related to debt market. To rate means the probability of a borrower to return the money with interest and in given time. This way lender know how much risk they are taking and interest is charged based on the risk. Higher the probability of default i.e. borrower not returning money, higher the interest is charged. These agencies base their calculation on the publicly available data as well as by talking to the company bosses for better understanding of the company balance sheet. The calculations involve complex mathematical formulas coupled with equally complex statistics. They take into account years of data across the spectrum and then come up minimum standard that has a letter grades. And the companies satisfying these standards qualify for the grade. Rating Agencies have also increased their gamut by adding everything under the sky. They even rate sovereign nations, unsurprisingly applying different scales for different nations.
In 1970’s government of United States granted a special status NRSRO i.e. Nationally Recognized Statistical Rating Organization- to certain rating agencies. Basically, government said that they trust these rating agencies for rating the debt market. Since then it became a rule for majority of mutual funds – the giants in the investing world – to buy the investment with certain minimum rating from these rating agencies. But the biggest use of Ratings is Risk Management division across the industry. Whether to invest or whether to lend depends on rating grade. With magic wand of ratings, risk management division decides or put restrictions on the business of lending or investing. Even if the rating criteria is internally developed, it still has to match or map it to the external rating grades i.e. NRSRO accredited ratings. And that’s precisely where trouble started. It was simply assumed that rating agencies know what to do and how to do their job. All though these rating agencies weren’t regulated or audited by government.
There is already a substantial argument against basing market behavior on rigid, one dimensional mathematical model. If history is the precursor then the one shouldn’t believe in such models at all. (LTCM, anyone?) As Prof. Taleb notes in his book ‘Black Swan’ in last century only ten days have had more trade than rest combined. And those ten days didn’t usher us into better world! In short humans behave rationally individually and stupidly in herds. But this argument is still raging and in absence of any worthy alternative markets will continue to rely on ratings and risk management models. So, stereotyping inherently irrational human behavior into math numbers wasn’t totally Rating Agencies fault. But giving rosy ratings to Structured debt and loans with shady origins was their fault.
One can discount such a blatant mismatch as a mistake but what’s interesting was the originators of the shady loans (originating, structuring and ultimately sale of debt is a long and complex process and will need a blog in itself to explain) used to pay fees to the rating agencies to find out how to make a low rated debt into high rated debt. In short, students after failing the test would go to t he teachers and pay them to get correct answers and re-submit the test again. The implication of such conflict of interest was felt through out the world as pension funds and mutual funds ended up buying such rigged investment blindly believing in the purity of the rating. And the Risk Management divisions, as mentioned earlier, based their ‘sound’ models on such ratings too. And as it became clear that the debt isn’t exactly of the high quality, the rating agencies decided to pull out the rug all at once. That was a double whammy because suddenly everyone is trying to sale such de-graded investments at once effectively accelerating credit crises. It’s rather banal to compare this scenario with pack of cards. Not that there weren’t fire alarms but they were conveniently forgotten. For example, the rating for WorldCom was BBB all most to the end when WorldCom filed for Bankruptcy then the biggest bankruptcy in US economic history. Same thing was repeated for Enron. Yet nothing happened and show went on.
And show will continue without even a blip this time too. The corrective measure is to actually challenge the existing notion of risk-management and free it from the clutches of morbid mathematical calculations. But that would be a long haul. In the mean time the sensible thing is to regulate the rating industry. Unfortunately, there aren’t any calls for that. They continue to remain de-facto kings in the investment world. With our money at their disposal they surely aren’t complaining!
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