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:
- Stocks Tumble on the Downgrades of Greece and Portugal Debt
- Asian Shares Nosedive on Downgrades
- 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.
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.