Think Twice Finance

The Financial-Crisis-Related Legal Investigations of Rating Agencies: Another Dry Hole

In an earlier post, I predicted that law suits against financial institutions flowing from the Subprime Mortgage Crisis will come to nothing. Not because the targets were not guilty of fraud. On the contrary, because they are guilty of fraud that had been encouraged by federal bank regulators, who are too powerful to touch, legally.

The rating agencies, I predict will also escape the lawsuits unscathed. In this case, because I doubt they are guilty of any crime.

They are accused on the one hand of not being sufficiently transparent. That is, of not explaining precisely how they reach their ratings conclusions.

Yet they are also accused on the other hand of providing institutions seeking a rating with advice on how do so. A conflict of interest, it is suggested. Transparently, the greater their guilt in the first accusation; the less, in the second.

We will never see an accusation where the true guilt lies – the governments’ collective decision to enshrine these specific rating agencies in the web of rules and regulations that govern trading and investment in government bonds. Absent this government sponsored monopoly, competition would determine the role and prominence of rating agencies. One outcome, indeed the outcome I predict, would be that rating agencies would disappear. The rating of bonds, like the touting of stocks, has always been and will always be a lucrative activity, vulnerable to conflict of interest from many sources. But I believe bonds, like stocks, should be rated by entities with some skin in the game.

The real problem with the ratings is that they have become arid statistical exercises, devoid of the judgment found in humans, not machines. Computers inevitably reduce rating to a procedure. Procedures are too easy to game. Bond traders think more deeply, or disappear.