Credit rating agencies
We have never been fans of credit rating agencies. They have been a poor substitute for due diligence of debt and investment alike. We can see where they may be a valuable service for retail investors, but never for institutions such as banks, pension funds, mutual funds, hedge funds, et cetera.
Let us compare the rating of investments to medical studies. Do you have more confidence in a medical study if the study is funded independently or by the manufacturer? Well, based upon studies of heuristics and biases, you would be quite reasonably correct to trust the independent study. Studies that are independently funded have a greater degree of long-term relevancy.
With rating agencies, companies are submitting to have their credit rated, and they are paying a fee to do so. Strike One.
Credit Rating agencies use a model based upon history. That is all they can look at because the financials you submit to them are outdated the day they are issued. While 20 years ago this was not much of a problem, times have changed, and today it is a serious problem because an investment that has a derivative component, or one with hidden leverage, can change drastically within hours. The credit rating agencies have not yet been able to sift through these complexities and rate the investments on specific sensitivity to market changes. Further, they have not been able to construct objective models weighting changes that can be positive or negative. Strike Two.
Studies have shown that junk bond portfolios have a better yield overall than highly rated bonds. Why is this? Because rating agencies generally rate smaller companies lower than larger companies. Why? Depth of assets is what we were told several times. But why do smaller companies do better. Simple: Reactivity. Smaller companies can react to a change in the marketplace much faster than can larger companies. Further, when larger companies do react, their very size and unison of action creates perturbations in the market place. This in turn often drives the market further against them. Yes, they have the depth of capital to react, but history, what the rating agencies rely on, is history and depth of capital when it moves will move the market against the larger companies. Strike Three.
What next? Credit Rating Agencies look at past acts, yet again. They look at “Aggressive Buy Outs” when rating companies owned by Private Equity firms. This will put those companies owned by aggressive buy out firms at a disadvantage when seeking additional financing. Aggressive Buy Out now being a pejorative in a third parties academicians eyes. They have been focusing on dividend recapitalization, the taking cash in dividends from subsidiaries to offset/recover acquisition costs. They are looking at how Private Equity firms carried out their financial strategies in the past to make rating decisions in the future.
Rating agencies are reacting to their failures by downgrading many investments from AAA to D in one month. These agencies were being paid a few million to rate these different midsized structures, and the wrong people were paying them.
The actions of the Rating Agencies is the equivalent of driving a car forward using only information from the rear view mirror – only an eternal optimist would be surprised when the collision occurred.
The Future? They are going to get sued and they are going to lose. New rating agencies will sprout up in the next year, both in Europe and Asia. Just as the markets have moved, so will the rating agencies.
