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Ratings Agencies Are Overrated


Why Ratings Agencies Who’ve Failed, Get A Pass

There was a recent article in the NY Times that asked a question most people haven’t had the time to think about, but is a great question nonetheless.  With the entire banking industry, AIG, the government, the auto industry, and the credit card industry all taking a serious blow both financially and in image, one question remains. How have the ratings agencies, who misrepresented the creditworthiness of massive pools of residential and commercial subprime mortgages, which  got our economy into the mess its currently in, escaped similar ridicule, regulation, and oversight?

First some facts:

– The ratings services play a crucial role in the capital markets, and virtually every investor, big or small, is affected by what they do.

– By law, banks and insurance companies must take ratings into account when investing in bonds.

– Big money managers, and their customers, often base investment guidelines on them.

sp-logo– Dominant agencies like Moody’s and Standard & Poor’s are paid by the companies whose securities they are evaluating, a blatant conflict of interests.

– The ratings agencies will rate any and every deal, regardless of the sponsor(s) or quality, leading to the misleading of eventual investors.

– Many people rely on credit agencies’ reports, yet the agencies, to date, bare none of the litigation risk for bad information.

– The Patriarch of ratings agencies, Moody’s share price is up over 40% for the year.

And now for the ultimate irony? Not even Warren E. Buffett, whose Berkshire Hathaway owns 20 percent of Moody’s, depends on ratings in making investment decisions.

The answer to the initial question posited in this post, is about as ambiguous as the correct solution to the problems it has created. To be fair, ratings agencies have not escaped all of the fallout from the credit crisis.  There have been cries for more oversight, reform to the system, and even removing first amendment right protections against lawsuits. Yet, as noted above, financially these companies seem unscathed, and their process continues to remain the status quo.

moodys-logoAll of that aside, there is another reason why they have remained relatively unharmed. The almighty dollar. Without companies paying ratings agencies to rate their securities, there is no income for the agencies.  Without income, they would cease to exist.  If they didn’t exist, the companies that pay them couldn’t effectively sell those securities to investors.

The only realistic alternative then is to have the ratings agencies controlled by, and operate as a quasi-government entity, similar to Fannie and Freddie. Then you would eliminate conflicts of interest, increase oversight, and eliminate the possibility that anything like this happens again. However, after spending three quarters of a trillion dollars of the taxpayers money to wade through the mess that has been created, and now that President Obama is calling for Pay as You Go to become law, I do not think that is going to happen anytime soon.

So what can be done?  Here’s a novel idea.  Instead of charging companies to rate securities, do it for free, and charge investors for reports.  This would eliminate any conflict of interests, and while investors may scoff at the concept of paying for information that may not lead to an investment, its still valuable to them, as it is still better than paying even more in the form of a bad investment decision. Greed is what drives investment, and investors’ greed for higher returns and better information will ultimately catapult this idea to the top if we, either through government action, or some other means, can break the stranglehold the oligopoly of Moody’s, Standard & Poor’s and Fitch have on the market.

This Post Has 2 Comments
  1. Two glaring issues with the argument, although, admittedly, I don’t have the answers either:

    “quasi-government entity, similar to Fannie and Freddie” – that didn’t work out so well for Fannie and Freddie, or their investors.

    “Charge investors for the reports” – “Not even Warren E. Buffett, whose Berkshire Hathaway owns 20 percent of Moody’s, depends on ratings in making investment decisions.” Who would pay? Not I.

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