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The credibility of credit rating agencies

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Bloomberg reports on the shaky credibility status of credit rating agencies:

Investors, traders and regulators have been questioning whether credit rating companies serve a good purpose ever since Enron Corp. imploded in 2001. Until four days before the Houston-based energy company filed for what was then the largest-ever U.S. bankruptcy, its debt had investment-grade stamps of approval from S&P, Moody’s and Fitch.

Indeed the financial meltdown was in part caused by these same credit rating agencies who rated Lehman Brothers bonds as A grade right till the day they filed for bankruptcy:

Grassi says the companies’ faulty debt analyses have been at the core of the global financial meltdown and the firms should be held accountable. Exhibit One is his own investment. He and his wife, Sally, held $40,000 in Lehman Brothers Holdings Inc. bonds because all three credit raters gave them at least an A rating — meaning they were a safe investment — right until Sept. 15, the day Lehman filed for bankruptcy.

The day Lehman filed for bankruptcy, S&P rated the investment bank’s debt as A, which according to S&P’s definition means a “strong” capacity to meet financial commitments. Moody’s rated Lehman A2 that day, which Moody’s defines as a “low credit risk.” Fitch gave Lehman a grade of A+, which it describes as “high credit quality.”

And to make matters worse, these rating agencies are supposed to be part of any financial rescue effort by the federal government.  More specifically the TALF (Term Asset-Backed Securities Loan Facility) plan as elaborated and criticised here, requires assets to be rated triple-A before they can be financed by non-recourse loans from the Fed. In short, the success of the Geithner plan depends heavily in part on whether credit rating agencies will grade reliably:

The Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF, will finance the purchase by taxpayers of as much as $1 trillion of new securities backed by consumer loans or other asset-backed debt — on the condition they have triple- A ratings.

And the Fed has also been buying commercial paper directly from companies since October, only if the debt has at least the equivalent of an A-1 rating, the second highest for short-term credit. The three rating companies graded Lehman debt A-1 the day it filed for bankruptcy.

Rather unsurprisingly the question of whether these agencies have conflicts of interest have popped out:

At the core of the rating system is an inherent conflict of interest, says Lawrence White, the Arthur E. Imperatore Professor of Economics at New York University in Manhattan. Credit raters are paid by the companies whose debt they analyze, so the ratings might reflect a bias, he says.

“So long as you are delegating these decisions to for- profit companies, inevitably there are going to be conflicts,” he says.

In a March 25 report, policy makers from the Group of 20 nations recommended that credit rating companies be supervised to provide more transparency, improve rating quality and avoid conflicts of interest. The G-20 didn’t offer specifics.

So what does it take to clean up Wall Street?  It isn’t easy for the government to simply step in and seize control of the financial markets since for one thing, banking has become a lot more complicated today than it was back in the 1930s.  It’s also a little disturbing to me at least, that these agencies have become so intertwined with the rest of Wall Street that we can’t quite rely on them as semi-objective indicators of credit worthiness any more.

Written by defennder

May 1, 2009 at 6:05 PM

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