Culpable Rating Agencies

S & P, Moody’s & Co., and Fitch–a portfolio manager tells me I shouldn’t overlook the culpability of these rating agencies for misjudging and then cloaking the risk involved in the sub-prime mortgage market. By law, investment banks and other financial entities would have been prohibited from adding so many risky mortgage-backed securities to their books. Pension funds, banks, money market funds, and insurers can only buy debt rated “investment grade” by a Nationally Recognized Statistical Ratings Organization (NRSRO). The SEC doles out this “recognition” and S&P, Moody’s, and Fitch are the only rating agencies so recognized. Since these rating agencies assessed the sub-prime packages as top shelf debt–AAA-the banks took the bait and swallowed the hook. When the debt was finally downgraded, the crunch followed. 

You would think that independent rating agencies would have every incentive to provide reliable information. But that would assume there was an open market for rating agencies, one without any barriers to entry. Unsurprisingly this is not so. According to Forbes

Regulators have long kept other agencies from competing with Moody’s, S&P and Fitch, despite their supporting roles in high-profile blowups like Enron and the 1997 Asian financial crisis. How? By requiring that only firms that the Securities and Exchange Commission designates as Nationally Recognized Statistical Ratings Organizations can be the final word on credit quality. Since the NRSRO designation is the only one that matters to world’s largest investors and financial institutions, Moody’s, S&P, and Fitch essentially have a lock on the trillions of dollars in debt issued each year…In order to be considered for the designation, the SEC requires a firm to be “nationally recognized” as an “issuer of credible and reliable ratings” by “the predominant users of securities ratings.” But since predominant users, like pension funds, are required to use NRSROs, smaller firms have a hard time meeting the “nationally recognized” threshold.

Yeah, go figure…

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