Tuesday, August 31, 2010

Rating Agencies

Rating agencies were back in the news last week. The Finance Minister of Canada wasn't too happy that Standard & Poors downgraded Ireland's debt. As quoted in the Globe and Mail, “You know, the rating agencies, quite frankly, were part of the problem that caused the crisis,” Mr. Flaherty said. “I’m not a big fan of Moody’s and Standard & Poor’s and so on when they start to pontificate on certain issues.”

Neither should you. The system of ratings is a deeply flawed system. Ratings are paid for by the debt issuers. In order to do a bond issue, I have to pay the rating agency to provide a rating for it. Of course, the better the rating I get for my bond, for example, the more demand I generate. There is too much incentive for me to "bonus" the rating agency in return for the rating I desire.

In defense of the rating agencies, one could argue that leading up to the recent market crash they were not able to fully comprehend the nuances of modern derivative products. To that, I would say, that didn't stop them from issuing a rating and pocketing the cheque for doing so. They say the ratings are "point in time", meaning as factors change, so do the ratings. So why didn't they? Incompetence is a poor defense of ignorance!

To make matters worse, there is no regulatory agency responsible for ratings. Instead, products need to be rated by two of the three large "quasi-regulatory" companies. The biggest firms hire their own ratings staff. Where do you think the best talent goes - to ratings agencies like Standard & Poors, or the big, high paying firms?

The other argument used to defend the actions of ratings agencies has been customers should never invest in things they don't understand. I couldn't agree more. So what is the purpose of the rating?!?

Again, it is the little guy who doesn't have access to a research staff who is most at risk. This is a case of damned if you don't, and damned if you do! I can't tell you what to do, but I ignore ratings. I do my homework. I stay away from derivatives and products we are not meant to understand. I invest in bonds using bond ETF's. I compare the advice of a really, really, good advisor to what I think I should do. Lastly, I listen to my gut. Even when everybody else is doing it, you can still end up losing your shirt!

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