Thursday, 23 October 2008

Rating agencies, a gentle defence

I have sometimes been a little obsessed by ratings agencies. I have worked for one, almost launched a news service covering them and they now form a large part of my grand unified theory of disintermediated markets (pt1), which one day I might share if I lock myself away and do something proper crazy like a Phd.

Anyway, the US Congress has decided (once again) to give the ratings agencies a kick, looking to make political capital out of their misery and mistakes. It's easy to see why, the agencies have not only been sloppy in their procedures and policies, but have allowed themselves to become inveigled into the global financial markets' regulatory system while taking little or no responsibility.

Because they have become involved in regulatory systems - sometimes one wonders against their own wishes - this gives journalists, aspiring politicians and prosecutors an easy opportunity to gain during these difficult times. Certainly some of the behaviour revealed recently does not look good.

However, I still believe that the agencies are more sad than mad. During the peak of the credit boom they were staffed by junior analysts (particularly in structured finance, where all the party-types worked) were poorly paid (by industry standards) and teams were regularly poached en masse by investment banks, which seemed to believe that agencies were perfect training grounds for up-and-coming deal structurers.

Overall, the problem, as Frank Partnoy argues, was often not the credit rating agencies, but those that decided to believe their ratings. Those in the market knew that rating agencies were not much use, unless you needed a rating to help sell your deal. Rating agencies give opinions on credit, not objective true assessments. Just as journalists on many newspapers give share tips, rating agencies gave their view on debt. The agencies' problem came when their ratings ('tips') became entrenched into the regulatory mechanisms of the emerging disintermediated economy. Agencies profited from this but failed to increase their standards sufficiently in case a time came when they came under intense scrutiny. To an extent they sowed what they will now reap.

However, the blame for the credit crunch does not really lie with the relatively small rating agencies, though they were clearly not perfect, it lies within humans failing to see risks for what they are, and being unprepared for how sudden change might come. Ultimately, the cause of the credit crunch is not criminal, however tempting that conclusion might be.

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