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  1. Wealth
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June 1, 2008

The Rating Game

By Spear's

In nature, ravaging fires or storms ultimately have a salutary effect on the whole eco-system. It enables the clear-out of overgrown flora and the destruction of unhealthy plants or animals and parasites. This in turn allows for new life to grow stronger, healthier, in a cleansed environment promoting evolution. In the financial world, it seems, things are quite different. Whilst a survival of the fittest is still the overriding trend, politics, connections and critical mass, even if parasitical and flawed, enable the less fit to live on.

A perfect example of this is rating agencies. Whilst banks exist mostly to make money out of other people’s money, their conflicts of interest are obvious for all to see and ultimately their management and shareholders tend to fall on their swollen profit-making sword when they get it wrong.

Rating agencies on the other hand present themselves as the Federal Drugs Agencies for the financial world, ennobling themselves with the vital role of ensuring that the paper-drugs peddled by the banks to all their customers are as described (in broad terms), and most of all, that the consumers should feel totally safe in their consumption. As long as the user abides by the ‘rating’ scale and only consumes what is thereby appropriate, the intended results will be achieved with no known side effects.

The problem is that nobody is really responsible for these rating agencies. Moody’s, Fitch and Standard & Poor’s are pretty much it when it comes to the ratings world, and enjoy a so-called oligopoly, which is as bad as it sounds. They are loosely regulated and supervised and have relied principally on a self-imposed ‘code of conduct’ for guidance only since 2004, following the Enron debacle. Their legitimacy is pretty much self-created, a little bit like a Nigerian investment scheme. The more financial drugs they ‘rate’ from the best paper-drug makers (banks), the more legitimacy they get. And so it is in their interest to be on best terms with the banks. And the more legitimacy they get, the more money they can get paid for ‘rating’ the paper-drugs.

Banks and other corporations ask them to be rated, in the knowledge that the higher the rating, the easier and cheaper it will be to borrow money from innocent bystanders. And so teams descend into the offices of the ratee and, using complicated analytical tools developed over the years at the expense of previous clients, they come up with a rating. They insist on paying themselves for every last coffee they are offered while rating the company to ensure there can be no perception of undue influence.

But forgetting that they do so with the money paid by the companies, they are rating at profit margins in excess of 50 per cent, according to some. Money which in turn they get from the consumers that buy the paper-drugs, which they only buy because the financial rating agencies assured them they were good for them and safe. And the more complicated the company, the more money they get paid, and the better rating they give, so the more the client can afford to pay. Somebody even spotted a possibly fortuitous link whereby the more complicated the product to rate, the higher the rating. This must be fortuitous.

The worst part is that the rating agencies ultimately bear little or no blame, suffer no meaningful financial or reputational trauma from getting it totally wrong and mis-labelling or mis-rating the paper-drugs, or failing to anticipate any of the violent side-effects of those incompetent ratings. Not only that, but once faced with dying patients around the globe, they just re-label the paper-drugs and carry on as before, pleased in the knowledge they have now ‘fixed’ their errors.

Owing to their oligopoly, the three main ratings incumbents suffer no meaningful consequences, as there is no-one else to fill the gap, the barriers to entry being just too high. Sadly, it is a very unnatural outcome to what should have been a chance for a new beginning in the ratings eco-system – a new beginning whereby perhaps the buyers of the products should pay for the rating work, rather than the seller. But therein lies the rub, we consumers are just too stingy to want to pay enough in the short term and end up paying much more in the long term. And the ratings boys can still laugh all the way to their badly rated bank.

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