x Abu Dhabi, UAEWednesday 17 January 2018

Behind a financial crisis you can find ratings agencies

A sordid little morality play is being acted out on Wall Street and in Washington.

Imagine you want to buy a car. You consult the available industry reviews and consumer reports and you base your choice on which make and model garners the highest ratings. Within months of buying your vehicle the wheels fall off. Only then do you learn the manufacturer that produced your clunker paid a stiff fee for those favourable reviews that played such a crucial role in your decision. Outraged? It gets worse. The same thing may have happened to your retirement plan.

A sordid little morality play is being acted out on Wall Street and in Washington, and the fact that it is getting so little attention suggests just how diabolical America's financial system has become. Among the many institutions repudiated by the financial crisis are Moody's Investor Services, Standard & Poor's, and Fitch, the Big Three credit ratings agencies that appraise the quality of securities coming to market.

It is this cartel that assigned their highest "Triple A" ratings to the kind of bundled assets that helped bring about the crash. They were valued in the hundreds of billions of dollars and most have been downgraded and are now worthless. What of it, one might counter. Anyone can make a US$100 billion (Dh367.33bn) mistake now and then, confuse investors and devastate global securities markets. Should we criminalise incompetence, just as Wall Street and Washington have privatised profit and socialised cost? Not if the neglect was unwitting. But like so many other sorry tales from the crypt of Wall Street credibility, it turns out the negligence was malign.

Unknown to many of the lay investors who relied on the ratings cartel for impartial guidance as they piled their savings into increasingly exotic instruments, the agencies were getting paid by the very issuers of the securities they were branding. In congressional testimony last month, former Moody's representatives acknowledged gross misconduct in an industry they said was lousy with conflicts of interest.

Scott McCleskey, the former head of compliance at Moody's, told legislators he alerted his superiors to widespread negligence and received a gag order for his trouble. He was also excluded from meetings between Moody's legal department and senior officials of the Securities and Exchange Commission (SEC). Eric Kolchinsky, an analyst and another former Moody's official, testified that he believed his colleagues issued credit ratings they new were inaccurate in blatant violation of securities laws. Not surprisingly, Moody's executives denied the charges.

This is not the first time legislators have called for action to be taken against the ratings cartel. Similar demands were heard seven years ago after the collapse of the energy giant Enron and the subsequent downgrading of energy traders. Then as now, politicians condemned the rating agencies "issuer pays" business model. Nothing was done, and if initial signs from this most recent display of congressional outrage is anything to go by, the Big Three may continue to rest easy.

Little in the way of concrete proposals has followed last month's hearings save for a few modest regulatory changes and recommendations of a larger regulatory role for the SEC, which was to the financial crisis what the Federal Emergency Management Agency was to Hurricane Katrina. Credit rating agencies are hugely important to the financial world. Their alphabet soup of appellations modulate a company's ability to raise or borrow money and the pricing of securities for purchase by banks, mutual funds and government pensions.

In some cases, bank regulators allowed lenders to hold lower levels of capital against "Triple A" assets. And yet, during the financial boom, the financial system was allowed to turn itself into a "Triple A machine", according to the Financial Times. The Big Three agencies - they dominate the ratings industry, which is also populated by a school of smaller, private firms - say their renderings are vital to the creation of a "level playing field" for investors both small and large. In fact, their history suggests they have done more to spoil pitches than straighten them.

As the economist Adam Posen and author David Smick have pointed out, the cartel issued fatuously high ratings ahead of the Latin debt crisis in the 1980s, the US savings and loan crisis of the 1980s and 1990s, the Mexican crisis of 1994-1995, the Asian financial crisis of 1997-1998, and the dot-com bubble of 1998-2001. The fact that the Big Three members have survived such a lamentable record suggests they, like so many of their clients, are too big to fail. This is good reason to dissolve them altogether.

The most serious economic decline since the Great Depression was caused in no small part by Wall Street's romance with high-yield, illiquid instruments that were unfathomable to many of the investors, professional as well as amateur, who invested in them. If the financial crisis has proved anything, it is that the credit-rating agency that can compete with the discipline of "buyer beware" restraint does not exist.

As Sanjeev Handa, the head of the public fixed-income giant TIAA-CREF, told the Financial Times last week: "Never buy anything you don't understand, whether it has a rating or not." @Email:business@thenational.ae