Tuesday, September 15, 2009

PROMISES KEPT

Barney Frank was interviewed on CNBC yesterday. Standard political stuff. This was all due to the lack of regulation, unconcern, the other guy's fault, blah, blah blah. But at the end of the interview he dropped a real bomb.The subject of the rating agencies came up and he said he was well aware that they had not performed well which had a great deal to do with the making of the crisis and one could well be sure that he was going to undo the regulations surrounding them. There was no follow-up to that stunner and not a word has been said regarding the single most definitive state made all of yesterday and one, if fulfilled (and if I heard correctly) could have the most immediate and far reaching effects on the financial business as we know it.

The agencies in question, primarily Moody's and Standard and Poors have a unique status in the financial world. By Congressional mandate, they are the only institutions allowed to issue value judgements as to the credit worthiness of debt issued in the public markets. When one hears the terms, "Triple A" or, Double B" this refers to the judgement made by these agencies as to a particular issue of debt. Keep in mind that the rating does not refer to the issuer but only to the rating on a particular piece of an issuer's debt. An issuer may have debt outstanding with different ratings; for example debt guaranteed by the U.S. Government or backed by collateral rated triple A will be rated triple A whilst a unsecured piece of debt from the same issuer may be rated well below triple A. Why is this important? Well, the rating is an assessment of risk and the lower the perceived risk, the lower the cost is to the issuer. Almost as important is the breath of the market for a particular issue as many investors are limited by law, statute, by-laws or internal investment guidelines as to how far down the risk matrix they may invest. Therefore, both the cost and the liquidity of a particular issue are greatly affected by the assigned rating.

Why, one may ask does an investor need rely on a rating agency? The answer is a part realistic and a part cynical. In some case a rating is require as explained above, but there is also a practical--and cynical--answer. Investors farm out the business of risk assessment because they have neither the time, personnel or, quite frankly, the inclination to do the job themselves. An investor is a yield whore: if he can find an appropriately rated risk at 5 basis points higher than the next guy, he gets the bonus. An investor seeks yield and leaves the assessment of risk to somebody else.

One can therefore easily understand what went wrong over the past few years. Investors blindly purchased all forms of highly rated debt instruments yielding slight better that comparatively rated instruments relying entirely on the assessment of the rating agencies. World-wide liquidity demanded more and greater opportunities for investment and these "structured financings" were churned out a record pace. It should have been clear that the sheer volume of issues had to raise questions regarding the ability of the rating agencies to do their job properly, but it did not. What resulted was a massive mispricing of risk that led to the debacle we have witnessed, or to put it another way, the rating agencies screwed up big time. There is far more that can be said but that is of no purpose.

Now, what did our boy Barney mean when he said he's going to overturn the legislation which grants this unique position to the rating agencies? To end their monopoly would be a good thing but politicians really love monopolies as long as they can control them. Did Charlie mean that they would be subject to massive government oversight in the future? Did he mean that their method of remuneration was to be changed from the rather quaint and ridiculous policy of having the issuer pay for the rating (no conflict there) to a concept of that the issuer pays (don't ask me how that works)? Does he mean to scrap the practice altogether which would throw a spanner into the works of the debt market of unimaginable size? Will the government mandate and delineate the guidelines and prerequisites ("In order for an issue to be rated Triple-A, cash flow must be...") for the obtaining of a sought-for rating? I sure wish somebody would ask Barney just what he meant cause this is not a little thing on the way to salvation. This affects trillions of dollars of debt issuance now and in the future.

1 comment:

  1. How do you regulat conflicts of interest in the ratings business. Investment banks pay Moody's, Fitch, and Standard & Poors to rate their bonds. The rating agencies often helped design the very bonds they rate. Rating agencies insist they don’t engage in this practice. And yet everyone on Wall Street know they do.

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