The Farce that is the Rating Agencies

I have heard a number of explanations for the financial crisis but the one group that tends to avoid the limelight has been the rating agencies.

They are a farce, and even worse, a farce with the power to make and break companies-and even countries.

What's even more galling is that under Basle II they gained "regulatory" powers in that the risk weightings for bank assets became predicated on the ratings granted by the agencies.

Whereas in the past risk weightings-which essentially are one of the ways that the Banking Regulatory Authorities manage reserves and thus leverage- the major distinction was between private and public debt. Even within public debt there was a distinction however. Only the debt of those countries who were members of the Organisation for Economic Cooperation and Development (OECD) was (essentially) considered "risk free". Everything else had a risk element attached to it thus attracting a higher reserve requirement.

Then came Basle II. New distinctions were brought to bear in the determination of risk requirements, and this time they were predicated on the rating opinions proffered by the rating agencies. Note the word "opinions". There is no legal recourse to a rating agency opinion as they publish opinions, which they hope but do not guaranty are correct.

Well first of all they are driving on the highway looking at the rear view mirror. Their record of rating changes tends to be a lagging as opposed to a leading indicator.

To be fair they were originally a sort of external credit department and their original expertise was in corporate debt. They would break down financial statements to understand companies and make some projections based on past performance and come up with a rating.

Enter the CDO market. It's attraction was that it came at a time of relatively low interest rates, and for the same rating yielded more than traditional paper. Now for most people if they are shown two things that are presented as being of the same quality but one is significantly cheaper than the other than the rational mind asks why.

Unfortunately, the rational mind didn't get a hearing. Worse, very few investors even bothered to look into the methodology being used to rate CDO's. They generally assumed that the traditional methods were applied. Very bad assumption.

What they did was take the ratings of the names in the CDO and then statistically come up with likelihoods of default/ability to pay. This was the time of the mathematical model. If everything always worked the way the model predicted it to work, no problem.

Of course the models couldn't detect fraud or irrational documentation like NINJA or any other self-certification loans, so of course the first rule of modeling was realised: GIGO(Garbage In Garbage Out for the uninitiated).

Now we have them jumping in with both feet to downgrade Greece, Portugal and Spain. Well it's not as if Greece got worse overnight. At a bare minimum it's been teetering since the beginning of the year. And if you really cared to dig it has been a problem since it entered the Euro.

So why did the agencies act now?

Interestingly the most recent news article on the OECD website, of which Greece is still a member, was from 24.3.10, so who knows what they are thinking.