Rating Agencies Became The Enemies During Financial Collapse.

Investors of all kinds, from small retail buyers to large banks, pension funds and their advisers rely on third party, arms length ”rating agencies” to do the dirty work in determining the real underlying worth of bonds and stocks–even those issued by sovereign governments.

The value of these services depends upon the agencies being unbiased.  But the truth is that ratings agencies, such as Fitch, Standard & Poors and Moody’s, are paid by both the “buy” and the “sell” side of the securities business. 

Buyers such as pension funds, corporations and commercial banks pay significant subscription fees to access security reports on almost all securities of any importance.   But securities issuers also paid the agencies to rate their securities.  And therein resides an obvious conflict of interest.  How could an agency give a client poor ratings and stay in business?  Working for the “sell” side, it was argued, would compromise agency ratings.  The agencies countered that they separated employee pay from revenue sources and that their reputation for unbiased reports was far more important to their success than satisfying the desires of any individual client who happens to be paying the bills.

Prior to the most recent financial meltdown, cracks appeared in the agency assertion that objectivity could be maintained while taking income from the “sell” side of the business.

The massive collapse of Enron signaled something might be structurally wrong.  That the comfortable days of being paid by sellers and buyers might be coming to an end. 

This from a New York Times article Dec. 16, 2001 about rating agencies failure in warning investors about the Enron collapse.

“NOW that the Enron wreck has moved to Capitol Hill, perhaps investors will finally learn exactly who knew the gory details about the company’s hidden leverage and when they knew them. Since deception appears to have been the Enron way, Congressional subpoena power may be the only mechanism to get to the bottom of this disclosure disaster.

It didn’t have to be this way. Although most of the usual suspects — the brokerage firm research analysts, the accounting firm, the investment bankers — performed admirably as Enron enablers, there is a group that could have asked tough questions to help investors assess the company’s risks.

These professionals toil at the nation’s debt rating agencies, Moody’s Investors Service, Standard & Poor’s and Fitch being the largest. They are independent people who analyze companies’ financial positions and assign to corporate debt issues various ratings reflecting the securities’ risks.

The fact that Enron was able to hide significant leverage and other obligations from the public puts rating agencies at something of a crossroads. While they have traditionally taken a non confrontational tack with the companies they follow, shying away from the role of credit cops, aggressive work from them is now more crucial than ever for investors trying to assess the risks lurking in the capital markets.

There are several reasons for that. First, rating agencies’ work on the risks inherent among issuers has grown more important as the corporate bond market has exploded in size. According to Thomson Financial, some $700 billion has been raised through issuance of corporate debt this year, triple the amount five years ago. And that’s the debt investors know about. We now know, courtesy of Enron, that companies may carry additional obligations that are hidden from investors’ view, shunted off the balance sheet but for which shareholders of the company remain on the hook.”

Beezer. Re-read that last sentence.  It was a clear signal from the Enron collapse that rating agencies were facing a much larger and possibly different set of challenges in rating company debt.   Off balance sheet commitments that entangled shareholders in camouflaged, risky bets, played a central role at Enron.  The same types of risky behaviour in the banking system this time around entangled not only shareholders but taxpayers too.  In the trillions of dollars.

And once again the ratings agencies were asleep at the switch.

And like the Enron debacle, Congress is going to ask rating agency heads why they failed to warn investors about the risks being layered on by banks.

From the Mcclatchy news service April 20.

Beezer here.  Not only has the bond market grown, but much if not most of this growth has come in the  form of synthetic securities classified as bonds.  Unlike most bonds however, these synthetics are extremely hard to accurately price and are therefore incredibly volatile.
The cure is simple.  Rating agencies must only represent the buy side.  Being paid by those selling securities should be outlawed.  Both the Enron and the current collapse clearly shows the current system allowing compensation from both sides no longer works.  If it every truly did.

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9 Responses to “Rating Agencies Became The Enemies During Financial Collapse.”

  1. Indira Mendiaz Says:

    I have so many mixed emotions when it comes to credit. In a lot of ways we need it. But I think the companies that run the credit abuse it and trick and take advantage of their customers. Too many people are in debt to have be all one big coincidence. I think the credit industry needs more regulation.

  2. Kareem Talleut Says:

    My husband and I filed bankruptcy 7 years ago. It wasn’t over credit cards, it was over car loans and a huge loan that we used our land as collateral. Since then we have both gone to college to get a degree so that we would make enough money. Now that the job market is in a slump, having a college education doesn’t seem worth it.

  3. pharmacy tech Says:

    found your site on del.icio.us today and really liked it.. i bookmarked it and will be back to check it out some more later

  4. capt aal Says:

    The only regulation needed is not with the credit industry but with the greed of the consumer.

  5. forex robot Says:

    nice post. thanks.

  6. Dov Henis Says:

    Greed Cancer Cells Also Follow Laws Of Evolution
    Failing Treatment Of Economic Collapse Simplified

    A. “Survival of the fittest: even cancer cells follow the laws of evolution”
    http://www.eurekalert.org/pub_releases/2008-08/foas-sot080108.php

    Of course. Expected. The cancered cells are proliferating. The energy constraint of their genome is enhanced. Their genes effect ingestion of the energy of their host cells in order to survive. They proliferate, evolve. Yes, theirs is a shorter survival time, postponement time of loss of energy, shorter than the survival time of uncancered organism’s cells. But, like and even more than most humans, they instinctively act per the encountered circumstances. This is evolution. This is natural evolution.

    B. Life genetics evolves via culture. In human culture one component is unique, it bypasses genetics.

    Culture is a ubiquitous biological entity
    http://www.the-scientist.com/community/posts/list/98.page#266

    There is natural ubiquitous evolution and there is human cultural evolution. Humans evolved language, that became a biological entity.

    Whereas nature’s evolutionary rungs are gains or losses of energy constraints for few “fittest” at ongoing circumstantial constellations, including modifications of genetic expressions, some Western cultured groups assess and extend the prospective temporal limits of evolution beyond the immediate scenario. They manipulate the circumstantial constellations, postponing or modifying natural evolution, to gain enhanced energy constraints for a community much larger than of “few fittest”. This is what all levels of politics are about. Local, national and international.

    C. Greed cancer cells also follow laws of evolution, with money being humans’ cultural energy.

    Not only physiological cancer cells follow the laws of evolution. Human greed cancer cells follow them, too. Evolution is evolution. EOTOE.

    The total amount of cosmic energy is constant even if mass diminishes with the ongoing expansion. Hence the universal melee of mass specimens to ingest each other’s energy to survive. Ingesting energy translates into ingesting mass, which is the other face of energy. Humans artificed money to stand for energy. The ideal ethical goal per the 20th-21st centuries technology culture is amassing money, the human energy artifact. Humanity’s present technology culture is founded on the brilliant idea that whereas in nature it takes work, converting of mass, to ‘amass’ energy, humans will – instead – print money, print it and base on it a make-belief culture, founded on make-belief energy. Printing money, posits the brilliant thinking, enables us to bypass nature, to spend more energy than we actually amassed.

    D. So again and again, the economic collapse will not be repaired by mechanisms but by basic cultural modifications

    The greed cancer cure requires a prolonged resolute determined change of culture, of values and ethics and goals, of consumption and living modes and patterns.

    Dov Henis
    (Comments From The 22nd Century)
    03.2010 Updated Life Manifest
    http://www.the-scientist.com/community/posts/list/54.page#5065
    Cosmic Evolution Simplified
    http://www.the-scientist.com/community/posts/list/240/122.page#4427

    ————–
    PS:
    Quote:
    Does the comment by Dov Henis make sense to anyone?
    Jared
    end quote

    Yes. It does. Plain and simple.
    The greed cancer evolved and persists biologically. “Human nature”. Its cure requires modifying of a natural process, i.e. cultural modification. Trials of various mechanisms within the present Technology Culture will not cure anything. They will ONLY buy VERY LITTLE time and will inevitably lead to a greater collapse…

    Plain and simple, but who is prepared to indulge in a prolonged resolute determined change of culture, of values and ethics and goals, of consumption and living modes and patterns. It is much easier to play hopeful make-belief with mechanisms…

    Dov Henis

  7. Chris Herbert Says:

    Interesting post. Unusual but interesting. I’m going with the idea that this greed cancer cell is not meant literally but methaphorically.

  8. Chris Herbert Says:

    metaphorically

  9. John Says:

    congratulations ! .. you have finally won a new reader ;)

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