Welcome Back.

In light of Buffet testifying before the Financial Crisis Inquiry Commission, it’s only fitting to discuss the credit rating agencies and how Congress is considering fixing their “moral hazards”.

The Start of It All: “Doing it for the Money”

At the peak of the housing boom, credit rating agencies began reevaluating their AAA debt ratings. In 2006, agencies like S&P and Moody’s were forced to redo their models but nothing was significantly changed.  At the height of the crisis, it was apparent that these ratings were incorrect and as a result a “whopping 91% of AAA-rated mortgage securities were downgraded to junk status”. Because these credit agencies are so highly relied upon by Wall Street, a shock spread across the market. It wasn’t long before the entire financial system was in midst of a collapse.

The government began an inquiry on the credit agencies failure to properly assess credit risk. As noted in an article from CNN, emails began to surface that agencies knew that the crisis was forming but kept company’s ratings high anyway. In one email, and employee wrote:

“This is frightening. It wreaks of greed, unregulated brokers, and ‘not so prudent’ lenders”

Why weren’t the agencies doing their jobs? They had no incentive to. Agencies get paid from the company’s they rate. If an agency downgrades their reliability, the company will stop paying for the ratings.

Ideas on How to Fix the Problem

I found a post via The Baseline Scenario blog: Reforming Credit Rating Agencies. Former analyst and then managing director at Moody’s Investors Service, Gary Witt, discusses what Congress wants to implement to resolve the credit agency issues as well as his opinion on the matter.

The Financial Stability Act of 2010 addresses what Congress believes should be done…  including making the SEC responsible for examining the agencies at least once a year and making key findings public. It will also give the SEC the power to fine agencies for any wrongdoing they find.

Witt addresses the same concerns I do. He believes that having the SEC oversee the credit agencies is necessary but is uncertain as to whether they have the right qualifications to take that responsibility. We have seen what damage can occur when employees not experienced in Wall Street attempt to regulate the market (i.e. Bernie Madoff). We have learned that regulators aren’t asking the right questions and until they are educated enough as to how to ask those questions, they should not be asked to hold responsibility for our financial markets. If the SEC is going to take over, they are going to need well-experienced rating agents and must provide them with an incentive to work there.

Witt first suggests that we eliminate AAA ratings. How could anyone be sure that an instrument is 100% riskless? Witt instead believes there should be five simple categories to rate credit risk:

“A for securities expected to lose under 0.1%, B for expected losses between 0.1% and 1%, C for expected losses from 1% to 5%, D for expected losses from 5% to 10% and F for securities expected losses between 10% and 20%.”

If a credit agency performs poorly (i.e. rates credit an A that ended up in a loss), then the SEC can fine them. Though the agencies are still being paid by the companies themselves, they have more of an incentive to make accurate predictions.

Another option is to get rid of the agencies. I find this option more appealing.

The financial industry has placed too much trust in these agencies. Credit agencies are simply financial astrologists attempting to predict the future. An agency telling you an instrument is AAA rated does not mean that you should believe it.

Always ask the right questions: Where did this information come from? How did they make their decisions? What types of models do they use to come to these conclusions? If these types of questions were asked prior to the collapse, many investors would have realized that these ratings made no sense.

Individuals must perform the necessary research in order to determine their own judgments of risk. The problem we are having is that we have too much confidence in the regulators, auditors, agencies, etc. when most are falling short of their responsibilities.

Have any ideas on how to resolve the credit agency problems? Send me an email at fraudgirl [at] simoleonsense.com.

See you next week.

- Fraud Girl