Mike Conlon
Senior Instructor
instructor@mywealth.com
Ratings Agencies No More?
S&P? Sayonara! Moody’s (MCO)? Muerte! Fitch? F*#&^d! You get the idea. Today the Attorney General of California, Jerry Brown, announced that he would be investigating the role the ratings agencies played in helping to cause the Great Recession. And I say it’s about time! For far too long these agencies have had a stranglehold over bond and credit markets and now the jig is up!
While this is nothing new considering the House Oversight Committee came to this conclusion back in an October 2008 hearing, now this opens the door for compensatory damages to be awarded to investors that were defrauded by negligent practices. If these companies do survive, look for increased competition from the investment banks and new regulations that will more properly define how these companies can make money.
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Here are some of the former practices which will hopefully be reformed and some of the ways that the ratings agencies should be fixed going forward.
For starters, the ratings agencies were paid by the same companies who insure and put out the bonds that are issued! This obvious conflict of interest led to “bid shopping”; whereby the company that gave the highest rating would be paid the most. This became a particularly heinous act when the highest ratings were given to subprime mortgage-backed securities when the agencies themselves knew those ratings were undeserved.
In this obvious breach of trust and power, many investors were duped into believing that they were buying safe and secure instruments only to find out later that they were anything but. Investment banks who participated in this scheme (yes even you Goldman) should be punished as well.
What this means going forward is that in order to maintain the true independence of these agencies, they have to change the compensation structure. Unfortunately, this means less money for these companies which means they have less money to pay competent employees, thereby exacerbating the “brain drain” that these firms are commonly known for.
The original intent of these firms was to protect the public and they have failed miserably. So what’s the solution?
Clearly there needs to be standards in place that are universal to all of the agencies and we need increased oversight by the appropriate authorities. Next, they need to remove the “pay for play” nature of the business and establish standard fees that the industry can charge. Then allow for additional compensation for actually being correct in their assessments. Their function in the marketplace is far too important to allow them to operate with the “weatherman mentality”, and they should be paid based on performance.
Hopefully, the government will come up with a way that these companies can get back to doing what they formerly did best, assessing risk in the markets and not trying to make a quick buck.
But as for right now, I don’t trust them. Who knows what else out there has been wrongly rated.
To learn more about how bond ratings can affect your portfolio, be sure to check out our investing courses.
