Saturday, 31 January 2009

Why are the Ratings Agencies getting away with it?

It might be because so many commentators cannot see the wood for the trees and/or do not understand the basics.*

As far as I can tell, and in my opinion, the biggest issue/factor in the downturn was the obscuring of risk. Those to blame? The rating agencies. 

If you had a security such as an SIV (bundled mortgage contracts with various cascades in case of payment and/or default) AAA rated with £143m assets yielding 5.5%, you might buy it at face if other asset-backed securities of AAA were yielding similar or lower returns. 

If the security was rated C, however, with the same £143m assets also yielding 5.5%, you would certainly buy it at a heavy discount.**  

This is what should have happened to the "toxic debt" right out the gate - sold on at a discount from the original lender. Had that actually happened at the very beginning, the assets would not have had to fall anywhere as far. Those holding them would not have such a hit in selling them on or, if they held on to them, damage to their balance sheets and Capital Adequacy. 

This did not happen. Rating agencies rated assets at AAA when they did not fully understand the risks. If they did not, they should have rated them as "junk" until they did understand. Why did they not do so? Fees paid by the seller of the assets. When you buy a house do you accept a survey on a house written by a surveyor paid by the owner of the house? No.**** 

We would have had a re-run of the "junk bond" event, for sure, but the impact would not have been anything quite as large or catastrophic (e.g. the cross-insurance issues***). Why are the rating agencies getting away with this? 

* It might also be that I have totally misunderstood those very basics!

** in addition, the insuring against default would have been far higher, so giving a buffer to the insurers to build up contingencies and caution to the purchaser.

*** Bank A sells SIV to Bank B, insured against default by Bank C. Bank C sells another SIV to Bank A, who insures it at Bank B. When the market goes down, all might want to claim, but all are paying out. FAIL.

**** This is why the whole HIP issue was a total waste of time if you took it at face value, i.e. in terms of sincerity. I do not, btw, I see it as a means to sneak in EU regulations about Energy Efficiency without appearing to do so.

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