Thursday, April 29, 2010

Rating agencies ... a big part of the rotten core financial system

Dear Colleagues

I have had an intense dislike of rating agencies for almost 30 years. It all started when credit cards were no longer given to trusted clients but to people with most suitable profiles. For many years I had been a "trusted" client and used credit cards as a sensible part of running my working life. I traveled extensively and a credit card was a tremendous convenience enabling me to work overseas for several months while carrying only a modest amount of cash.

My payment history was erratic ... I paid down the balance when I returned to the USA, and ignored all of this while I was travelling. I did this for about 15 years, and it worked very well. And then along came the "credit bureaus" and their "profiling". My erratic payment history earned me very low marks and my interest rate shot up from almost nothing to something over 20%. In all of history this type of interest charge has been called "usury" and has been illegal ... but not now in modern banking! I have not had much nice to say about credit card companies and the "credit bureau" world since that time. They have adopted technology and use it to "profit" and the concept of "service" has been eliminated.

In the Community Analytics (CA) system of metrics much of the profit of the credit card industry comes from value destruction for the clients who most need a good service! It would have been nice for my old ... and very good ... banking relationship to have transferred to the new technology based profiling system for credit cards ... but it never did. It was an early warning of worse to come!

Rating agencies are nothing more than a bigger version of the credit bureaus. They do more sophisticated mathematics, but at the end of the day they produce a simple metric to represent the quality of the underlying security. My impression is that rating agencies are doing complex mathematics that I cannot understand, and very little of common sense that I do understand. I have had conversations about some of the modeling ... and I know some of the real world situations to which the models relate ... and the lack of understandable correlation is mind-boggling. Of course, rating agencies are not being paid to provide common sense assessment, they are paid for the complex and totally opaque conclusions that result in the "rating". They have become major money makers in the Wall Street scene!

Most of the time nothing bad happens ... and it really does not matter whether the rating was AAA or something much lower. But when there is turmoil ... which there is from time to time ... it is only then that the true underlying strength of the security becomes apparent. The rating agencies labelled an awful lot of really low grade securities with a Triple A rating ... showing that either (1) their models are not worth very much; or, (2) they function in a perfectly fraudulent manner. It is difficult to know which. Both are bad news for a serious society.

In other posts I have spoken well of the way Goldman Sachs handled the sub-prime mortgage debacle and the fall out from this. By contrast, I think that the work of the rating agencies was a central flaw in the debacle, and I see very little that suggests that they contributed anything but dangerous misinformation into the run-up to the crisis.

What am I missing?

Peter Burgess

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