It's About Time!!

It’s finally happened. Since the beginning of the financial crisis, there have been victims, criminals, and all around blame scattering. The reasons for this are obvious, and, in some cases, I agreed with the pundits, professors, and politicians (yes…even politicians…I did say ‘some cases’ after all) on where this blame was being placed. However, there was one sub-industry on Wall St. that was conspicuously missing from the scrutiny that the big banks and insurance companies were facing. Since the day I began understanding the mechanisms that caused the near collapse of Wall St., I wondered why this group was not at the center of it all.

Well, I’ll stop the teasing and tell you that the group is the Credit Agencies. I’ve always felt that these agencies, of which there are three major ones (Moody’s, Fitch, and Standard & Poors), played an integral role in the mistakes that allowed the financial crisis to occur. If you recall from previous posts, one of the root causes of the crisis were Mortgage Back Securities that were created by banks and sold to investors. Eventually, the quality of the mortgages that were being put in the securities dwindled drastically. However, investors continued purchasing them. Well, the credit agency’s role is to notify these investors of the quality of the mortgages. They put a credit rating to the security (much like the credit ratings you and I have), and that, in turn, allowed buyers to assess the riskiness of what they’re buying.

However, somewhere along the way, the credit agencies seemed to have gotten short-sighted because the poor quality mortgages that were put into the MBS’s were, in many cases, given good credit ratings, thereby providing investors with a false sense of confidence in what they’re buying.

As you can probably see, the credit ratings were really the checkpoint to make sure that the MBS market didn’t get out of whack like it did. I’ve been wondering for the last 2 years why their feet weren’t being held to the fire. But it finally looks like all that is going to change…

Finally – Some Scrutiny

I’m not going to get into the details of what scrutiny the agencies are now receiving. Although this may seem odd, there’s two simple reasons I do this: 1) I think the investigations are more politically motivated than anything and, therefore, it’s hard to say if there’s going to be any real changes coming out from them and, 2) This post is already long enough.

Nonetheless, if you’d like to learn about the investigations, take a look here

Where Things Should Change

Now that the ratings agencies are being combed over for their role in the crisis, I’m hoping there will be some wholesale changes in how they’re allowed to do business. The most obvious change that NEEDS to happen is their revenue structure. Right now, the agencies are hired by banks to provide ratings to the securities those banks are creating. The banks then generally take the best ratings and advertise those to investors. Well there’s obviously a gap here – the same people you’re supposed scrutinize are paying your bills! I think there needs to be some regulations put in place for how these credit ratings operate to eliminate these ovbvious conflicts of interest. Here’s my top 3 changes:

1. Create a pool to which banks will be required to contribute. This pool will then be used to pay credit agencies for their work and, knowing that their money is coming from the pool and not directly from the bank requesting the rating, the credit agencies is less likely to artificially inflate ratings.

2. Along with the first change, you also have to change disclosure rules so that ALL ratings for the security must be disclosed to investors so investors can have a full picture of the security’s risk assessment. To offset this, you can have the requestors of the credit ratings pay for each of the ratings.

3. Create a government regulatory group (probably within the SEC) whose sole function is to audit the Credit Agencies and ensure that they’re ratings processes are consistent and accurate.

I’m glad to see the credit ratings agencies being scrutinized for their role in the crisis. I find it surprising that a business model so entangled with conflicts of interest has been allowed to exist. The changes I’ve suggested, although fairly drastic, I think would be a great way to eliminate the conflicts inherent in the current system.

What are your thoughts?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.