Think Twice Finance

The Rating Agencies: Buried in the Sand to the Neck as The Tide Creeps In.

God, but I’m good. Know how to tell? Just read the title of the May 24^th post. OK, I’ll cite it myself – “The Rating Agencies: Are They Doomed?” Now we learn that the SEC is giving serious thought to cutting off the agencies’ government-mandated monopoly status. (WSJ, June 24, 2008.)

A month ago the rating agencies were taking beaucoup de heat, but to suggest they were doomed was considered the muttering of a lunatic. I was that lunatic.

What they were going to be, in the common view, is more transparent. That is, far from removing their regulation-based monopoly, the agencies were to continue to divide the righteous from the damned, but they would have to explain their decision. My quarrel with that approach a month ago was that divulging the decision factors in advance would render their decisions completely predictable – hence, alas, irrelevant to investors.

Like the Wizard of Oz, they would become less formidable when it is disclosed that there is just some guy pulling some strings that makes the decrees.

So, to be honest, I envisaged some sort of slow decline into obscurity and bureaucratization for the Rating Agencies. But taking away their monopoly isn’t like that at all. It’s more like Alexander the Great cutting the Gordian Knot. The market will state right now that rating agencies have no magic formula and allow the competitive gates to be thrown open to other ratings providers. Everyone and his brother will be able to rate bonds.

The result of that is highly predictable. There will be hundreds of rating agencies. Their predictive success will determine their importance as rating agencies. They will have good years and bad years. And the marginal value of a single agencies’ prediction to the investment community? About the same as the fee a mutual fund manager who discloses his holdings in advance could charge. 0.

There is an old rule of finance that determines this outcome. If you have no skin in the game, write a book. If you have your own money at risk, we’ll read it.