Aside from banks such as Citigroup, Merrill Lynch and UBS (who between them have dropped more than US$30 billion and counting), some of the biggest victims of the sub-prime credit crunch have been the reputations of ratings agencies, Standard and Poor’s, Moody’s and Fitch. The ratings agencies were again found to be asleep at the wheel, after allegedly failing to adequately acknowledge the risks attaching to collateralised debt obligations.
Bethany McLean, the writer who was the first to out Enron (and recently criticised Macquarie Bank), looks to have again followed the line taken by renowned short seller, Jim Chanos (Chanos has shorted Moody’s stock). McLean, writing in Fortune , explained that:
[After home] buyers with less than stellar credit were approved for a mortgage, lenders would bundle a bunch of iffy loans and sell them to investment banks, which would repackage these into Franken-loans and sell them to investors.
By working hand-in-glove with the rating agencies — which were paid large fees for their involvement — institutions managed to get masses of these mortgage-backed securities rated investment grade. All of a sudden risky consumer loans were reconstituted into — presto! — something seemingly no more risky than a government Treasury bond.
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Rating agencies face a similar conflict to that of independent experts – that is, they are paid by the very people upon whom they are assessing. Ratings agencies are paid hefty sums by bond issuers to assess the creditworthiness of the asset. Moody’s is a stand-alone publicly listed company on the NYSE, while S&P is part of publisher McGraw Hill – both have to earn a return for shareholders.
Criticisms of ratings agencies performance with respect to collateralised debt obligations aren’t new. Back in July (before the sub-prime dramas really took hold), Fortune noted that the Attorney-General of Ohio, Marc Dann, was preparing a case against the three big ratings agencies. Dann claimed that:
The ratings agencies cashed a check every time one of these subprime pools was created and an offering was made [and the agencies] continued to rate these things AAA. [So they are] among the people who aided and abetted this continuing fraud.
By rating the sub-prime investments highly, many pension funds which should have been prevented, were able to purchase the assets (pension funds are in most instances, restricted from acquiring ‘non-investment grade’ bonds).
The recent sub-prime stumbles don’t represent the first time serious questions have been asked of ratings agencies. In the classic book, F.I.A.S.C.O , former Morgan Stanley bond salesman, Frank Partnoy, (referring to the collapse of Orange County, then the largest municipal bankruptcy in history) noted that:
[Orange County’s] bankruptcy filing made the ratings agencies look like fools. Just a few months before, in August 1994, Moody’s Investors Service had given Orange County’s debt a rating of Aa1, the highest rating of any California county. A cover memo to the rating letter stated, “Well done, Orange County.”
Now, on December 7, an embarrassed Moody’s declared Orange County’s bonds to be “junk”–and Moody’s was regarded as the most sophisticated ratings agency. The other major agencies, including S&P, also had failed to anticipate the bankruptcy. Soon these agencies would face lawsuits related to their practice of rating derivatives.
The ongoing role of the credit agencies was well summed up by Chanos to McLean, when he noted simply that “If the rating agencies will downgrade only when we can all see the losses, then why do we need the rating agencies?”