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The Fiasco of Credit Ratings

December 11, 2008

A lot has been written and said over print and motion media about the impending economic doom. And the bailouts and the ‘stimulus packages’ along with it.

And change too. After all, an entire country turned its page over this one word. But a lot of things have to be fixed this time.

Let us start this time a pointwise introspection of the present investment scenario.

  • Soon after the dot com bubble burst, the Fed reduced its interest rates making it extremely easy to borrow money.
  • Borrowing money came along with a huge baggage of leverage which corporates happily took care of.
  • But credit ratings, never faltered, never changed. The bonds of a company with highly leveraged business could have AAA bonds.
  • Because of an appropriate riskless rating from agencies, the credit default swaps[CDS] also jumped to make the most of the money.
  • Incidentally, the CDS writers wrote the swaps in an assumption that, the institutions are strong and robust enough for agencies to hand it an AAA, so why-on-earth should it go bankrupt.
  • Today, a fall of the realty bubble has changed the credit worthiness of the entire financial area.
  • But when the CDS issues rolled into unknown territories of highly leveraged companies like Bears and Stearns and Lehmann’s, the swap buyers came back in hordes to pinch those who took unaccounted leverage. The widespread default put an acceleration to the fiasco.
  • As the bailouts and handouts have become common, people are finding it difficult to regain the trust back.

Of important consideration is, the last point. Governments and power to be are making it sure, that sufficient liquidity is injected into the system. But the lack of a risk taking ability is hurting the economy badly. If one has to take into consideration the reason for this, it is the whole-sale scale of  the crappy information disbursal system in place.

The FITCH, MOODY’s and S&P’s of the world have clearly failed the investor, institutional and retail as well, in alerting the dual edged sword of leverage. The leverage has come back to haunt the corporates, who took it like fish to water, but now are finding it difficult to live without. This very scenario, the credit rating agencies should have talked us about.

Investors are finding it difficult to renew their risk appetites. This has come in the light of the breakdown of the basic information system- the credit worthiness of a particular company.

To put things in light, Exxon was till the day before it registered for bankruptcy, continued to command an AAA bond yield. Same with AIG, Bears and Stearns and Lehmann’s. The basic tenet of capitalism is the ‘invisble hand of markets’, the efficient one. For this, the fact, that price discovery is done by an effective information arbitrage has been hit at the guts.

An investor on the road can’t even believe if the credit rating for Microsoft  is true or not. A late action is still better than none. In a surprising move, a lot many companies have been downgraded by these credit agency.

To better the things, one might suggest a higher accountability from the credit rating agencies. Yet, there are many faults in this. For one, the credit rating agencies are paid by the corporates, who of course find it in their interest to get AAA approved or any such ratings which they don’t deserve. Two effects are there. Firstly, they have the advantage of better response to their debt issues and secondly lower bond yield.

Hence having accountability in such cases is a tricky business. For one, if corporates dont pay the credit rating agencies, then who will? Definitely not the investors! Hence you can very well have a perspective where the interest lies.

So what are the problems if  investors do chip in? Having the investors pay for the ratings is difficult to engage in the preliminary case because of problems like free-riding and difference in fees which might prove difficult to standardize. For instance, if Fitch says a particular company is AAb and S&P says, its AAA,then definitely the pricing of CDS and other debt related instruments will vary[both due to credit worthiness and fees of credit agency factored in].

In effect, today what has been driven home fair and square is how much blame do the credit rating agencies will have to take share for this fiasco. Already lots of damage has been done due to faulty ratings.But the intelligentsia and elites are doing seldom few to take care of things. And as the storm rages outside and panic grips the market tighter, investors are afraid of even the moving curtains in the dark.

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