As an element in the ongoing political battle for financial reform in the US, the newspapers report a victory for the rating agencies. Well, sort of.
First, for those who have not yet heard of rating agencies, an ultra-short primer. A rating agency is a commercial company that produces ratings of various debt instruments, paid for by the issuer. The ratings are supposed to be based on a thorough analysis of the issuers' ability to repay the debt. There are three US based rating agencies that have government authorisation, Moody's, Standard and Poor's, and Fitch. Across the world, pension funds and insurance companies have used the ratings to "control risk" in their portfolios.
Many of financial institutions have a provision that if one of the rating agencies has issued a rating below investment grade, the institution simply cannot hold the security in their portfolios. US government agencies are required to use the ratings. Further, the ratings agencies have been protected under a peculiar interpretation of the Constitution, whereby their ratings were considered an expression of "free speech", meaning that it was impossible to sue them for any kind of malpractice. Their ratings are – despite the supposedly thorough analysis – just an opinion.
In the aftermath of the dotcom bubble, the reputation of the agencies took a bad hit, as the ratings of companies such as Enron dropped from the coveted AAA to "junk" in a matter of weeks before the company went bankruptcy (and months after the stock price had fallen by more than 90%). Surely the ratings agencies should have seen it coming, if they really had checked the books.
In the wake of the Sub-Prime Crisis it became abundantly clear that the rating agencies had "adapted" to the wishes of the issuers and had bestowed their highest ratings on packages of dodgy debt based on a paper-thin assurance from badly capitalised insurers. Who had by the way also been rated by the very same rating agencies.
And most recently, the rating agencies began to meddle with the EU as they have lowered the rating of Greek debt to "junk" status, despite a massive underwriting by the EU. Yes, the rating agencies defend themselves, but the underwriting will end in three years. Apparently their experience with both Sub-Prime issues and Enron or WorldCom have taught them a lesson about being ahead of the curve. But many institutional investors decided not to sell their holdings of Greek government debt, breaking with the diktat from the agencies.
Now their previously unassailable status is under heavy attack. The EU is actively trying to promote European rating agencies. The planned US reform of the financial sector will most likely lead to a change in the constitutional protection (so they can be sued for telling fibs), US government agencies will not any longer be required to use the services of the rating agencies. There will have to be far more openness and transparency about their ratings and analysis.
Amid all this bad news for the rating agencies, it is made out to be a victory that the US Congress has dropped an idea of assigning rating assignments on a random basis. Some victory.
For the rest of us who take an interest in risk management, what is going on is highly interesting. In a recent blog post I laid out how some of the thinking members of the financial community have arrived at the conclusion that mathematical models of risk are useless when they are most needed.
Now all of those who had used ratings as an excuse for independent thinking are receiving yet another blow. If you cannot consider the ratings as the results of proper diligence, how should you then manage a portfolio of debt instruments? I am afraid that I again come back to my conviction that there is no alternative to independent thinking.
In the real world, businessmen know that there is no such thing as a free lunch. Risk exists, even if you would really, really like it to go away (or to be sold off in tasty little morsels). Faced with this categorical imperative, too many risk managers have for too long relied on mathematical models and ratings. The mathematical models are built on assumptions alien to the real world. Ratings are issued by commercial companies who have shown clearly that ratings are a product which can be moulded to the clients' needs. For sure it is not quite as independent and well-founded as rating agencies would like us to believe.
Risk managers of the world, unite. You have everything to lose if you don't start thinking.