It would take a fairly large stretch of imagination to believe that my local McDonald’s could be awarded a Michelin star. There are no truffles on the burgers, no champagne at the soda fountain.
It would take a similar leap of faith to believe that a pack of securities and derivatives drawn up on the back of loans made to America’s least creditworthy individuals is worthy of a rating in line with the debt of General Electric.
But that is exactly what Standard & Poor’s (S&P) and Moody’s, the biggest ratings agencies, asked us to believe. In recent months, S&P’s bond rating arm and its rival have been forced to downgrade mortgage-backed securities tied to such subprime loans, effectively admitting that their advice was way off beam.
Now, investors are looking for scapegoats as they chalk up billions in losses because those uncreditworthy mortgage holders have gone into default. S&P and the others who gave high ratings to these obviously weak securities and derivatives must clearly shoulder a good amount of the blame for pumping up this balloon of problem debt. But simple changes of personnel are not enough to fix the problem. McGraw-Hill replaced the top executive at its rating agency, Standard & Poor’s, amid rising criticism of the firm’s failure to warn investors of the risks of investing in subprime mortgage-backed securities. McGraw said Kathleen Corbet, S&P’s president, will be replaced by Deven Sharma, a senior McGraw executive.
The ratings agencies rely upon information supplied to them by the issuers of debt to come up with their ratings. If the information is flawed then it follows that the ratings will be flawed. What is more, during the past few years, a large chunk of S&P’s revenue has come from rating these structured-finance products, which bring in more fees than rating corporate and municipal bonds.
As such there is a clear conflict of interest between issuers and agencies on the one hand and investors on the other in a business that has immense power in global financial markets—some of it enshrined in laws and regulations.
Unless these relationships undergo a radical overhaul to inject true independence and greater competition into the ratings process the markets will continue to consume Big Macs labelled foie and continue to suffer unexpected bouts of indigestion as a result.