Friday, May 1, 2009

Ratings Agencies - Aarrgh!

Has anyone else in the finance industry noticed this: when you speak to people that know nothing about finance, they can very quickly point out large gaping inconsistencies, flaws in logic, and conflicts of interest that happen all the time in the financial industry?  One such conflict of interest is the way ratings agencies are paid to rate bonds and other investment vehicles.  The current system has agencies (i.e., S&P) getting paid to rate investments by the investment banks that underwrite new offerings.  Obviously this doesn't work since the i-bank gets paid only if the offering is successful...and the successful offering hinges on those ratings being positive.  A third grader could see that this would lead to good ratings being given to junk investments.       

In a previous post I stated that the SEC has sure taken its sweet-ass time in making credit analysts pay the piper for their incompetence and/or misconduct.  I heard an interview this morning with William D. Cohan, author of House of Cards, where he discussed the role of ratings agencies in the subprime scandal.  Mr. Cohen echoed my point that agencies like S&P, Moody's, and Fitch are largely to blame for the tremendous losses experienced by pension funds and individual investors who foolishly believed that when an agency says something is a good investment....that thing is actually a good investment.  He also wrote a very good article for Fortune where he tells the story of McGraw-Hill's headaches over its subsidiary S&P - the conduct of which was explained as "a bone-chilling definition of corruption." 

It's obvious that ratings agencies should no longer be incentivized to rubber stamp dog shit investments.  What isn't obvious is 1) what should be done to punish those analysts that produced bogus ratings, and 2) who should, in the future, pay analysts to rate investments.  It obviously doesn't work to have the underwriters pay for ratings.  It also obviously doesn't work to have companies pay for ratings.  Investors already pay for ratings reports, so I'm not sure it makes sense to have them pay more.  That leads me to think maybe the SEC should pay for ratings, since, as a regulatory agency, it's their job to ensure investments are correctly rated, and it would be in everyone's best interest to have investments priced properly (proper pricing is a topic for another day - I have a bone to pick with Black and Scholes and Brownian motion, for that matter).  

Bottom line: when you're thinking of investing, take a hint from the X Files and Trust No One.      

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