Quis Custodiet ipsos Custodes?

Who will rate the raters?

Of all the actors in the financial crisis, the ratings agencies have seen little pain from their abysmal miscalculations. While they collected hundreds of millions in fees rating thousands of deals, 92% of the AAA-rated sub-prime bonds from ’06 and ’07 have been downgraded to junk status. Who pays for these kinds of errors?

We all do, really. The overconfidence of the issuer banks in their own AAA deals helped sink Bear, Lehman, Merrill, and Citi. These failures were at the heart of the financial crisis. It didn’t hurt that AAA bonds ironically required less capital to be set aside. This encouraged a lot of European banks to load up.

The agencies’ issuer-pays business model is part of the problem. But it’s really more a matter of regulatory capture. The ratings agencies are like for-profit regulators. Where’s the rater’s next job going to come from? Another problem is the demand for higher ratings didn’t just come from sellers; buyers wanted them, too, to help juice yields in a low-return environment.

Ratings are like speed limits: we know we need them, but nobody likes them. In the end, the market needs to have a place where people can offer opinions without getting sued. And while investors can do much of their own homework, regulators need the ratings to help measure risk. Prudent investors use ratings, but don’t rely on them.

For the moment, the only sensible reform is this: caveat emptor. Working with a torn safety net can be more dangerous than working with none at all.

Douglas R. Tengdin, CFA
Chief Investment Officer
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By | 2014-09-05T18:49:19+00:00 May 4th, 2010|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. –
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