Damn! I listened to my son again. He tells me that nobody read blogs over the weekend so don't worry about not writing one on Fridays. So I listened to him, got involved watching the U.S. Open and got scooped.
Today, the Wall Street Journal's second editorial was about the elephant in the room, the rating agencies. It is absolutely astounding that throughout all this discussion of overhaul of the financial system, the rating agencies get nary a mention and yet so much of the ill that occurred can be traced directly to the reliance of the marketplace to the ratings of debt issues provided by the agencies. A quick explanation of their function might well be in order.
One should keep in mind that the agencies do not rate companies per se. What they rate are debt obligations of the companies and these obligations are rated individually. Therefore, a senior debt issue of a company might be rated in one manner whilst a subordinated debt issue might well have an entirely different rating. These rating are vitally important to the distribution mechanism because often by law or corporate governance many investors are limited in regarding to ratings as to the type of investment they can make. Therefore, if a pension plan for example can invest in only single-A rated issues the market for triple-B rated issues is greatly diminished. Hence, get the rating you need. In addition many investors do not have staffs capable of analyzing the huge number of debt issuance such as occurred over the past few years and therefore, reliance upon the ratings provided by the agencies became commonplace. On two levels, therefore, the rating agencies became vital to the workings of the system.
Now one would think that those who relied upon this expertise would pay for it; think again. The agencies were paid for their service not by the investors but by the issuers. Conflict of interest you say? Perhaps. There is certainly a risk of that. However, more importantly, one must question whether the sheer volume of issuance over the past five years was simply too great for the few agencies charged with the protection of the investors--by Congress, mind you--to fully and professionally perform their duties...especially when they are paid by the number of ratings issued. And now we begin to se why, perhaps, the elephant went unnoticed; whenever anything can be traced back to a Washington involvement it tends to disappear. Odd, that.
The relationship between issuers and the rating agencies is a close one. It is not a, "Hey Joe, what kind of rating will this get?" Oh no. It's more like, "Hey Joe, I need a triple-A for my client base. How do I get there?" If there were hard and fast rules, that might be one thing, but as we have seen, the incredibly complexity of the instruments created in the near-past made the rating of every issue bespoke and entailed a great deal of input just from the standpoint of what was being created and how from the issuers/creators. It was a system rife with the threat of misunderstanding and misuse. And of course it got worse. It wasn't long before folks began to look at CDSs issued by Triple-A issuers such as AIG as carrying the same credit rating. We know how that movie ended. And as the WSJ pointed out due to the Basel rules relating to bank capital, banks holding Triple-A rated paper could include the same within their capital base thereby presenting a false picture as to the health of the system.
Amazingly, little has changed despite the disaster this system created. For certain there was inappropriate collusion between issuers and rater but at the end of the day it was laziness on the part of investors that should be blamed for what occurred and the system that encouraged it. They made it too easy. While at present there is a heightened awareness, it is still too easy. In a few short years the awareness will have diminished and unless this part of the play is rewritten, Act II is going to be ugly.
Tomorrow, let's talk about corporate governance and my friend, Dick.
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