Thursday, October 23, 2008

Shakespeare and the Credit Rating Agencies

The current crisis in the financial markets is being portrayed as, above all, a failure of trust. Banks are seeking unreasonably high rates to lend to each other because they don't know who is hiding skeletons in the closet and may be teetering on the brink of insolvency. But if you really want to understand the concept of trust squandered, you would do well to look at the plight of the credit rating agencies.

These companies slapped attractive ratings on dubious mortgage-backed securities. Investors then snapped up the securities, reassured by the seals of approval bestowed by Moody's and S&P. Of course the ratings agencies had a conflict of interest so huge it was surprising that Washington regulators never had a Homer Simpson “d’oh” moment: Whichever bank created a security also paid for it to be rated. It's like a poor student who can buy good grades, except with more disastrous consequences, as we are now seeing.

How bad did it get? In an informal instant message exchange in April of last year, one S&P official expressed skepticism to another about a mortgage-backed security, saying the model being used for the rating “does not capture half the risk.” Then she made the snarky remark: “It could be structured by cows and we would rate it.”

Credit rating agencies are edging toward irrelevancy because they compromised their ideals and let their names be sullied in pursuit of short-term profits. Their very business model relies on their reputation and integrity of their work. When investors lose faith in their ability to evaluate products and entities, their role in the financial system becomes entirely superfluous.

They would be wise to remember Shakespeare who once wrote wisely, “He who steals my purse steals trash/but he that filches from me my good name robs me of that which not enriches him and makes me poor indeed.”