Why did the ratings agencies do such a bad job?
The standard answer is that their business model is flawed. Ratings agencies assess credit risk and are paid for their services by the issuers. Aren’t they conflicted?
Not really. The ratings agencies started out with a subscription model where the users paid, but switched to issuer-pays in the ‘70s, when photocopiers made it impossible for them to protect their reports. But there has been no upward drift in ratings since then. The number of triple-A companies has gone from 58 in the mid-‘70s to 22 in 2000 to only 9 now. Some grade inflation!
If it becomes known that an agency’s good ratings can be bought, the ratings and ratings agencies will become worthless. Sure, raters are subject to financial, political, and bureaucratic pressures; but so is every large company. And this isn’t the first time the agencies blew it: Enron was still rated investment grade just four days before it declared bankruptcy.
No, these agencies were subject to the same errors that every human agency is: humanity is born to trouble as the sparks fly upwards. Small errors by the raters cascaded to larger errors by investors which led to systemic problems in the economy. Increasing political control or adding to disclosure rules won’t change this. The only solution is increased investor skepticism and vigilance. As one old hand has said, “Moody’s never paid a coupon.”
Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!
Follow me on Twitter @GlobalMarketUpd