Why Do We Still Listen to the Ratings Agencies?

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Something bizarre is going on. How can investors put so much faith back into the very institutions that have, at least partially, created the great financial collapse?

After all that we've learned about shoddy practices, perverse incentives, and highly questionable ethics, should we still give a damn when Moody's (NYSE: MCO  ) or McGraw-Hill's (NYSE: MHP  ) Standard & Poor's downgrades Greek debt or Portuguese debt or the debt of anything, anywhere, anytime?

Have they earned this power?
This is all quite ridiculous. Within the last week, I've been bombarded with headlines that read something like:

  1. Stocks Tumble on the Downgrades of Greece and Portugal Debt
  2. Asian Shares Nosedive on Downgrades
  3. Debt Contagion Fear Spreads in Europe as S&P Lowers Eurozone Credit Ratings

Rarely does one, single event explain an entire market's movements, but the facts here are hard to dispute. On April 27, Greek and Portuguese sovereign downgrades were published on the Standard & Poor's website at 11:22 a.m. and 10:50 a.m., respectively. Immediately prior to that, the S&P 500 was humming along, opening at $1,209.92 and hitting a daily high of $1,211.38 at roughly 10:50 a.m. Then something went dreadfully wrong.

Within minutes, the S&P 500 fell sharply. It's fairly safe to assume that the primary reason why the market tanked some 2.3% that day was because of S&P's actions. Clearly, Americans still care what these institutions have to say. The U.S. markets were not alone.

Markets around the world fared similarly terribly. The Shanghai Composite index tumbled 2.1%, the German DAX fell 2.7%, Brazil's Bovespa nosedived 3.4%. Imagine how many tens of billions in global wealth evaporated fairly instantly thanks to the actions of a few credit analysts sitting in an office somewhere. The question is: Who gave them permission to wield so much power?  

Meet the ratings agencies
Incredulous is the only word that captures my sentiment. When I spend time thinking about the true role of the ratings agencies within our economy, both past and present, I recall the special contempt I have for these institutions.

For one, the mere existence of a credit rating system has the tendency to lure investors into a false sense of security, accelerating a failure of due diligence. This is bad enough, but ratings agencies have also never really delivered a great product, which only exacerbates my frustration. The best illustration of this point can be found where ratings agencies and large financial institutions meet.

Nuclear meltdown
Bankers are traditionally driven to make as much money as possible for their firms and themselves. While bankers were successful in this regard (make no mistake, they were very successful), employees at credit ratings agencies, whose primary responsibility is the objective evaluation of financial products sold by bankers, have completely and indisputably failed.

Ratings agencies serve no purpose other than to honestly quantify an entity's ability to make good on its financial obligations. Over the past decade, however, S&P and Moody's grew to be so concerned with rating products of increasing volume and complexity created by institutions ranging from Citigroup to Deutsche Bank that they completely forgot their greater role in society.

New and exotic business for the agencies meant new fees to collect. As you can imagine, the incentive to just toe the line and offer their de facto stamp of approval (an investment grade rating) to whatever product crossed their path became very great. They had no interest in rocking the boat, and we've all witnessed the fallout of this decision.

AAA is a joke
The ratings agencies have never, even vaguely attempted to take their vital responsibility as seriously as it needs to be taken. If they did, the twisted relationships and perverse compensation structures that can be found across the industry simply would not exist. It doesn't take a rocket scientist to indentify specific environments in which objectivity can be distorted or completely eliminated.

Rather than an objective, muscular counterpart to a bloodthirsty financial monster, ratings agencies evolved into eager puppies, willing to do whatever was asked in order to go along for the ride. All the while, the world grew to view these institutions as trusted, one-stop shops for risk quantification, a perception that neither company ever attempted to meaningfully rebut.

Of all parties involved in the financial collapse, I blame the ratings agencies most. Everyone else was, at least, doing the job they were given to do and doing it pretty darn well -- risk management officers exempted.

Evil or ignorant?
There is some question whether this failure to effectively evaluate everything from credit default swaps to the chances that General Motors would go bust was a function of a back-slapping, palm-greasing relationship with Wall Street or simply a lack of available knowledge. To quote the ever-quotable Michael Lewis in his new book, The Big Short, the folks at Moody's and S&P, " … appeared to know enough to justify their jobs, and nothing more."

The line here between ignorance and dutiful compliance is thin and not meaningful. Though many have alleged that the ratings agencies were on the take outright, it doesn't really matter if they were or weren't. Essentially, the ratings agencies were either crooked or they were stupid. Either way, they're guilty.

When the public relies on you to assess the quality of many trillions of dollars worth of debt and you are unable (or unwilling) to do this well, you fail as epically terribly as they have. This, of course, makes me wonder why we still listen so carefully when they make their calls. In the absence of an effective substitute, I can see why people still want to hear what the major ratings agencies have to say, but is their dubious opinion still worth so many billions of dollars?

Let new blood flow on the Street
A fresh player is needed within the business. The credit ratings agencies are highly regulated, enjoying a quasi-monopoly status that prohibits new entrants into the industry. The best way, therefore, to improve the system is to allow new players into the field that can catalyze change. The only name I know of that is making a move is Morningstar (Nasdaq: MORN  ) and, as a shareholder, I'm counting on the company to bring new blood to the industry.

Warren Buffett, a longtime holder and believer in the business models of the ratings agencies, has been slowly but surely liquidating Berkshire-Hathaway's (NYSE: BRK-A  ) multibillion stake in Moody's. Why? It's quite possible Buffett is equally disenchanted with the way these folks do business and has simply had enough. Or perhaps he sees the business model crumbling before his eyes.

On your side, perhaps the best thing to do is to just take a step back the next time the ratings agencies make a "big call." They don't exactly have a great track record.

Fool Nick Kapur can get fired-up sometimes. He owns shares of Morningstar. Moody's, Berkshire Hathaway, and Morningstar are Motley Fool Stock Advisor recommendations. Berkshire is also an Inside Value recommendation. The Fool owns shares of Morningstar and Berkshire.  The Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (28)

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  • Report this Comment On May 03, 2010, at 12:43 PM, Roadwarriors57 wrote:

    We listen to rating agencies because they have been accurate 99.9% of the time for the past 50 years.

    If you are going to try and make the asumption that Buffet agrees with you then at least get the facts right.

    Buffet was quioted today as stating....."There is obviously a backlash against rating agencies," he said. "If they are not forced to change the whole structure around them ... in some dramatic way, it's a pretty darn good business."

  • Report this Comment On May 03, 2010, at 2:54 PM, plange01 wrote:

    rating agencys had little to nothing to do with the financial collapse..this blame will land on companys like goldman sacks companys like this disgrace will be closed....

  • Report this Comment On May 03, 2010, at 4:56 PM, ryanalexanderson wrote:

    >We listen to rating agencies because they have been accurate 99.9% of the time for the past 50 years.

    >If you are going to try and make the asumption that Buffet agrees with you then at least get the facts right.

    If you are going to argue with the author, get your own "asumptions" right. Or at least cite something, when you state silly figures like 99.9%.

    The Municipal Bond Fairness Act (HR 6308) states that 2% of Moody's investment grade bonds have defaulted and 4% of S&P's have. Bear in mind, these aren't the number of times that Moody's and S&P have been <i>wrong</i>; these are times that they have been <i>gloriously wrong and caught out</i>. Lots of crap companies manage to squeak through and pay bondholders without being "investment grade".

  • Report this Comment On May 03, 2010, at 6:09 PM, RideHD wrote:

    Amen. And if you think Moody's and Standard and Poor's had "little to nothing" to do with the CDO/CDS catastrophe at Goldman's, think again. They let Goldman pass them re-packaged CDO's created from BBB-rated sub-prime mortgage bond "towers" -- the bottom tier -- and then blessed 80% of those as AAA/Aaa. Worse, Goldman's then re-packaged the 20% that didn't make it and sent them through again with a "What do you think" memo with the same 80% upgrade rate.

    I agree with the author. These rating agencies, in these instances at least, were either corrupt or completely negligent; and they were so while making a lot of money on what they were doing. Goldman was criminal in how it deceived its bond investors here, especially when they went so far as to create "Synthetic CDOs" and continued to follow Barry (the first guy to short them) in shorting them via AIG CDS's. Side bets on a corrupt mortgage bond market -- and sadly, a bond market that served the nation well in the 1980s to bring down mortgage interest rates through the original mortgage "tower" concept. They turned it into a criminal act and should be punished as such.

  • Report this Comment On May 03, 2010, at 6:18 PM, goalie37 wrote:

    The majority of traders who follow these rating agencies are usually operating under a time horizon that is far too short for the ratings to have any meaning.

  • Report this Comment On May 04, 2010, at 7:02 AM, CajunRon50 wrote:

    The author makes a lot of "opinion" statements but I'm not seeing ta whole lot of evidence to back up his accusations. I would also be interested in what REALISTIC alternative he thinks can replace the current system..another government agency or government regulation?

    I would really need to see hard evidence to these accusations before getting on board with alternatives.

  • Report this Comment On May 04, 2010, at 11:31 AM, BMFPitt wrote:

    In my mind, it's not a question of why the markets freaked out about Greek debt after the downgrade, as it's a question of why they didn't know it was junk well before that time?

  • Report this Comment On May 05, 2010, at 9:15 AM, TMFOpie wrote:

    The biggest problem that beset the ratings agencies is that they chased profits by trying to rate the plethora of complex structured finance products. And they were paid handsomely for this service over the years because these were very, very high margin products. But they couldn't handle the volume or complexity, pretended they new what they were doing, and paid the price. As did shareholders. But their record and service in rating sovereign debt and traditional corporate/muni debt is much better. It's just that this business doesn't carry the margins that SF does. So Moodys and S&P will be different beasts over the next decade than they were over the last five; they will be more like they used to before the derivatives and housing explosion.

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