Standard & Poor’s, Moody’s Investor Services, Fitch Ratings. Do those names sounds familiar? Maybe one or two, but probably not all three. What about Experian, TransUnion, and Equifax? They sound familiar right?
You should know the 2nd three are the credit agencies that work with lenders to establish your credit ratings and scores. The 1st three provide a similar service to corporations and debt securities. Imagine if I were GE and wanted to issue $10 billion in corporate debt to fund a new project for the company. S&P, Moody’s, or Fitch would rate the debt so that investors will know how risky these bonds will be. They don’t do credit scores, but each have their own (very similar) rating systems. You can see what they look like here.
When we’re looking for credit a potential lender pulls up our credit report at no cost to us. But what if you were responsible for furnishing your own credit report for the lender? You could go to any of the three to get it. Maybe TransUnion gave you a bad report but Equifax had a better one. You’d go with Equifax and take that to the banker. And since the agencies would have to compete for your business there would be a conflict of interest in that they may bend their rules for the chance to do your report.
Thankfully that doesn’t exist. That would cause some serious problems in consumer finance. But, in corporate finance it’s a whole different ball game. In fact, this is in fact the ball game they played with our mortgages. The way this worked was an investment banker could take his mortgage-backed security to a rating agency and shop around to see which would give him a better grade. This of course can lead to investors being fooled into buying what is rated as a high quality security when it is in fact less so. The degree of which this has occurred and to what extent will never be known, but it did happen. When the topic came up on tightening the standards the co-director of CDO (collateralized debt obligations, basically pooled debt investments that would have mortgages and other kinds of bonds in them) ratings at S&P said “Don’t kill the golden goose.” More disturbingly, an SEC report quoted an unidentified analyst as saying Let’s hope we are all wealthy and retired by the time this house of cards falters ;o)”. Yes, it really ended with a winky face.
But the ratings agencies stand by their legal loophole, they are in fact only offering opinions. So when S&P rates an MBS (mortgage-backed security) AAA they are only saying in their opinion this is one of the safest investments out there. What a cushy friggin position to be in. Dominating in an oligopoly with more than enough business to go around and all you’re doing is offering opinions. You don’t have to worry about credibility, because everyone else is chocking up crap opinions too.
Generally I don’t like government stepping on toes, but I am in support of some kind of change to the compensation system for these ratings companies. Morgan Stanley should not be able to pay the rating agency that gives them the best score. I can’t propose a change because I don’t know enough about the business, but a change is needed.
Congress is huffing and puffing finally after two years of people like me knowing about this but the media not covering it. They want to make the ratings agencies liable for their opinions and perhaps create a system where the agencies would police each other. Sounds great, but I lack the faith in them to actually accomplish this. I don’t want the companies to be responsible for the things that have already occurred, but I do want them to own up to it going forward. Keep your eyes on these happenings. The media has largely ignored what is in my opinion the biggest secret issue on Wall Street today.
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 By The Weakonomist |
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I definitely agree with you. This was one of the main reasons that so many toxic assets came into existence and it was largely ignored by the media. It would be great if there was some sort of regulatory body or if they policed each other, but somehow it doesn’t seem like that would be a very objective way of going about it, even if it were to happen. I guess time will tell how this works out… -Mike