Dangerous Letters Game

1-3 letters is all it takes to rate a country, a company and/or its financial securities. To indicate, for better or worse, the health of the entity as it stands now and is likely to in the foreseeable future. The ratings are said to affect borrowing costs, the capital flows in an out of the country or firm, asset pricing, forecasts and opinions. Investment grade ratings range from (for S&P) AAA (no risk of default) to BBB after which a security is classified as 'high yield' or 'junk' down to C (highest risk of default). They are significant and are monitored closely by analysts across the globe. Hence in essence, a rating identifies the risk associated with investing into the entity in question. Or does it?

The USA downgrade from AAA rating to AA+ on the 5^th of August 2011 was predicted by many to cause calamity in the markets. Leading editors of the world’s prominent financial publications voiced their concerns on the impact the downgrade could have once markets would open the following Monday, August 8^th. However, widespread panic never occurred and the most important indicators reveal what little real impact the downgrade has had. American Treasury yields, which many experts were certain would increase to compensate for the higher risk, remain at near 2%, even falling to 1.875% on September 21^st, the lowest point since figures dating back to 1953. US debt is still regarded as the safest in the world by the markets, with or without AAA.

Mortgage Backed Securities (MBS) leading up to the financial crisis were complex constructs of mortgages that when packaged by financial engineers at the most prominent of investment banks often received high (investment grade) ratings by leading agencies. However, apart from the handful of people that designed them, nobody knew how they were constructed and what constituted an MBS (often loans from overexposed borrowers with little chance of paying back when house prices stopped rising). Least of all the rating agencies that rated these securities as safe and upon whose judgement of A or AA vast fortunes were invested up until 2008. The subprime mortgage crisis eventually took its toll, wiping out Billions of Dollars that may never have gone lost had the rating agencies been able to calculate the true risk they labelled as safe. This is another case in which ratings turned out to be near meaningless.

Example of the construct of a MBS, little understood by ratings agencies

                                                                                                                                            Source: Wikipedia

Additionally to not always having an impact, the process of rating a country or firm may be risky in itself. The highly publicized downgrading of the USA by S&P could have easily led to a downgrade war amongst rating agencies (S&P, Moody’s, Fitch) as these private companies vie for attention and may not have wanted to feel ‘left behind’ in any bold moves that give their competitors an advantage. Thankfully, a downgrade war with real impact and amplification of market fears has not taken hold.  Similarly, there is an incentive problem as rating agencies are paid to rate the securities of firms by the very firms that issue them. If you are given money to rate someone’s merchandise you do not want to tell them it is highly dangerous as this will prompt them to go to your competitor that may be less harsh, leaving you empty handed.

Ratings agencies should be nationalised. This would mitigate the possibility of downgrade wars and incentive issues, both aspects coming naturally in privatised, open-market competitive moves that can serve a firm well but are in this context out of place. A rating needs to reflect risk as it most accurately can be, not as it most favourably can be to serve the interests of the rating agency.  

Make no mistake, ratings do remain important, especially to value for example countries investors have little knowledge about (frontier economies come to mind such as Colombia which is investment grade rated which will likely be important to it and help it gain FDI). However, ratings are not the end-all “stamp of approval” to determine the standing of the rated entity.  Investment professionals and the media need to regard ratings as nothing more than a support to an argument, not as the source of an argument.

Comments?

Further Reading:

http://www.bloomberg.com/news/2011-04-13/moody-s-s-p-caved-to-mortgage-pressure-by-goldman-ubs-levin-report-says.html
http://news.yahoo.com/geithner-u-treasuries-still-safe-downgrade-225436759.html