"Rating Agencies - Do We Need Them?"

Sydney M. Williams

Thought of the Day

“Rating Agencies – Do We Need Them?”

May 3, 2010

The Financial Reform Bill, so highly touted by President Obama (to such an extent that he has suggested that whomever is against it must be in the pay of Wall Street fat cats!), leaves unmolested such root causes of the credit crisis as Fannie Mae and Freddie Mac, along with their incestuous relationship with Congress. The Bill also largely excuses the rating agencies from regulation, despite the role they played in being so quick to accord AAA ratings to thousands of structured mortgage products, many of which sank beneath the waves.

One of the more fascinating factors of the financial wonderland in which we live and work is that investing in equities (the riskier of the two asset classes – bonds being the other) has long relied on independent research. Bond investors, on the other hand, have largely depended upon the ratings from services such as Moody’s, Standard & Poor’s and Fitch. Since the rating agencies are paid for by the businesses, or governments, which they rate, they could be viewed as nothing more than glorified, over-priced financial public relation companies, masquerading as independent research firms. That’s probably too harsh, but you get my point. While most companies have investor relations departments, or hire financial public relation firms to promote their stocks, most investors – both retail and institutional – rely on independent analysis by firms such as ours, or on their own analysts.

It is true that many “buy-side” firms employ credit analysts and that a number of brokerage firms do as well, but they are frequently tucked away receiving little of the glory (or the notoriety) that frequently descends upon equity analysts.

Individual investors are the ones most reliant on the rating agencies; so were the ones who suffered most grievously, in part, due to the lack of honest diligence and disclosure on the part of the rating agencies.

In an editorial on Sunday, the New York Times, stated that “reform bills before Congress have only vague proposals to fix the rating agencies…” The Times, not surprisingly, urged that the agencies “should be financed like a public good, with a tax or other levy, and paid by the government.” But after watching what government did to the two GSEs, Fannie Mae and Freddie Mac, it is difficult to imagine that government is the best arbiter as to what constitutes risk and what does not. The better solution, what the Times refers to as a “drastic step”, would be to simply let them disappear. The result would be an increase in independent fixed income research and more open, honest and efficient pricing of bonds and other fixed income instruments.

So, my answer, despite the defense of Moody’s by Warren Buffett over the weekend (Mr. Buffett, an owner, has been selling the stock recently), to the question in the header is “no”. The void created by their demise would be filled by creative, entrepreneurial firms specializing in credit research and whose clients would be investors, not issuers. Those firms, either old or new, would then become the equivalent in fixed income research to what firms like Sanford Bernstein or Monness, Crespi, Hardt & Co. are to equity research.