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Ratings Agencies Still Scot Free


For all the anger being lashed out at bank employees compensation. Bank CEOs have been grilled, even Greenspan has been lambasted (rightly). But what about the ratings agencies?? They were mostly responsible for the growth of CDOs, rating them AAA when only a small component of those CDOs consist of AAA borrowers. Without their implicit approval, the investment banks could not have managed to lure so many investors to buy these so called triple A rated papers. Just a notch below AAA would have seen these CDOs growth cut by a substantial amount. Its not the first time ratings agencies have "helped" to create troubles for the global financial markets. You can name Enron, Worldcom and now CDOs. These buggers get their rating fees upfront and not even a slap on the wrists. I would suggest that Moodys, Fitch and S&P be fined the sum of all fees received from rating the CDOs for 2004-2008. There has to be punitive action. I certainly hope that the upcoming G20 meeting will see some "action" on these ratings agencies.

Sydney Morning Herald: Ratings agencies such as Moody's Investor Services, Standard & Poors and Fitch rule the roost. They decide who is risky and who is safe. But how scientific are these ratings? Who is on the judging panel? And how accurate are they? Let's start at the last question. In terms of accuracy, their record is nothing short of appalling.

These are the are people who brought you Enron, who claimed the biggest corporate scam in US history was a fabulous investment opportunity just a few weeks before it collapsed. And not just Enron. The agencies gave the nod of approval to a whole range of dotcom darlings, including Worldcom, which lost billions of dollars in shareholder funds and where executives found themselves before courts and in jail.

But if you thought they'd learnt from that horrible and hugely embarrassing experience, you'd be dead wrong. Because around the time they were copping a shellacking over the dotcom collapse, in 2001, the ratings agencies were sowing the seeds for the downfall of the Western capitalist system as we know it

A huge number of unscrupulous participants played a role in the American real estate boom that has since brought the system to its knees. But it was the ratings agencies that provided the legitimacy for America's investment banks to pump up the market, to sell collections of high-risk loans to vast numbers of unsophisticated investors around the world, and all under the mask of a gold-plated AAA rating.

Just in case you missed the point, you had subprime loans to home buyers - which by definition were loans to people with a history of default - being packaged up, diced and spliced and repackaged as low-risk investments. The "mortgage-backed securities" were repackaged into "collateralised debt obligations" and Wall Street investment bankers sold them as safe investments to dentists in Norway, country councils in Australia and anyone else with more dollars than sense. Those who tipped in their money thought it was a terrific deal: a huge return on a AAA-rated investment. If only they'd known those selling them laughingly referred to them as "the cream of the crap".

So what is wrong with the ratings system? For a start, it involves an enormous conflict of interest. Those with the product - not the client or the investor - pay for the rating. From the ratings agency's perspective, it's easier to make money that way.

When it is just companies or governments issuing debt, the potential conflict is bad enough. To get a decent rating, you have to pay all three of the main agencies. And not just for the initial rating. There is an ongoing annual fee that gets levied so you can maintain your rating. And guess what happens if you don't pay that fee? Well, the ratings agency decides it doesn't have quite enough information and it downgrades your debt, which in turn raises the interest you pay to the lenders. What would you do in that situation? You'd pay up, that's what.

The whole thing smacks of extortion. But if the situation was bad with governments and corporations, when it came to the brave new world of "structured finance", the ratings agencies lost all control and all respect. As the US property boom took off, a huge number of organisations were issuing a vast array of property-related investments. The agencies began clambering over each other to rate the CDOs - the toxic products into which the Obama Administration is now forced to tip trillions of dollars to save the American banking system - as AAA.

Investors who bought those loans on their coveted AAA clearly did not want them downgraded even when the economy began to tank. And, as it transpired, the ratings agencies had never even contemplated factoring a property downturn into their calculations. Instead of providing a sobering influence, the ratings agencies pumped up the boom. So far, their role in the global financial crisis has been largely overlooked. A US Senate committee last October subjected the heads of the three main firms - all of whom had earned megamillion-dollar salaries through the boom - to an embarrassing grilling. But now they are back at it, as though nothing has happened. It is business as usual.


p/s photos: Kathy Chow Man Kei

Comments

Geoff said…
In one word-conduct your own research. These ratings agencies are part of a lumbering infrastructure to converge fund manager's investment decisions. You can't take a pee without them saying so.The funds that did well this time around are not those "guided" by these ratings.
Bee See said…
I know this is random, but I was wondering if a Malaysian resident can purchase US stocks(i.e. Microsoft, Google).If so, could I know how I can do that? Thank you in advance.
Salvatore_Dali said…
geoff,

to be fair, there is no way any investor could have done their research in CDOs... every offering had more than a hundred pages in lawyer's print... Buffett said that there was no way he could make sense of the documents... so how to do research???
ratings agencies are paid handsomely to rate the papers... if doctors made the wrong prescriotion and kills or severely injures the patient, that doctor can be sued... if you are a soil engineer n made erroneous calculations, causing buildings or bridges to collapse, you could be sued and barred for a lot of money and a long time... so, when ratings agencies make their ratings, AND investors all RELIED on those ratings... n many lost their houses and jobs and investments, why shouldn't they face punishment... whether WE CAN do the research ourselves is not the issue, what about those who cannot???

Bee See,
u can buy through most major brokers, though they will charge relatively high commissions, i think CIMB and maybe OSK can do... u want to save costs, can try Options Express in Singapore, go n open account there... or open an ETrade account in HK .
Andrew Chua said…
Bee See,

If only there were some ETF's that could give us exposure to overseas markets, that'd be nice. But somehow ETFs just don't seem to be catching on here in Malaysia.


Dali,

She's so beautiful.
Geoff said…
I wonder how John Paulson could put on a huge bet on these CDOs and mortgage securities without some kind of independent research.He is one of the highly publicised ones, I am sure there are others.
Andrew Chua said…
Geoff,

Maybe we can equate the Ratings to Audit Reports. When we research public companies, we do it with the assumption that the audited figures were audited according to the prescribed standards. I don't think many people will perform the audit work all over again in the name of independent research just because there is a possibility that the auditor is negligent. It just isn't cost effective.

The fault lies with the person who didn't do his job properly, more than it lies with the person who trusted the work.

After all, all trade and commerce is based on a certain measure of trust.

But it is also true that with amounts so huge, those big boys should have been more prudent.